Contents

Alternative assets

Microfinance movements

New initiatives to bring micro-financing into the mainstream?

Micro-financing is moving closer to a more mainstream presence in capital markets following two new initiatives announced over the past week. S&P has launched a rating methodology for microfinance CLOs, while the IFC is pursuing the implementation of Sharia-compliant microfinance programmes.

An increase in demand for funding in the microfinance sector is leading many microfinance institutions (MFIs) and microfinance investment fund managers (MIMs) to look beyond their traditional funding bases - primarily socially responsible investors, foundations and multilateral institutions - and consider securitisation as a financing option, according to S&P. Indeed, a number of microfinance CLOs have been completed over the past year - including MILAA from Standard Chartered and the IFC (see SCI issue 89), and a number of smaller, private deals. However, S&P suggests that the relative scarcity of securities analysis and industry benchmarks has constrained the growth of the microfinance securitisation market.

Gary Kochubka, senior director at S&P, comments that microfinance securitisations currently in the pipeline have been impacted by market conditions and have delayed their launch. "But in line with S&P's goals in making our methodologies transparent and available to the public, coupled with the increased interest from the market (issuers and investors) and a pipeline of potential transactions, we have published this methodology at this time," he says.

Kochubka adds: "The microfinance industry has indicated itself that it needs to attract investors beyond its traditional group. This asset class provides a further diversification of investment options for institutional investors who are interested in achieving a level of return but also contributing to a social mission, known as 'double-bottom line'."

S&P's new methodology for microfinance securitisations will incorporate elements of its rating methodologies for both CDOs and consumer finance, with adjustments to address factors specific to emerging markets and the microfinance sector. Microfinance securitisations will be separated into two categories: 'multiple-MFI transactions' - those that consist of loans from various third parties (including MIMs, multilateral institutions, and commercial and investment banks) to multiple MFIs; and 'single-MFI transactions' - those that consist of loans that a single MFI (or a network of related MFIs) has issued to its borrowers.

S&P says it will use the CDO Evaluator model when analysing pools of loans for multiple-MFI transactions, but will use a methodology consistent with those for rating existing-asset securitisations when analysing pools of consumer, SME or mortgage loans in single-MFI transactions. Evaluator will calculate the expected default rate for each rating category of a multiple-MFI securitisation - it determines the gross default rate by running a Monte Carlo simulation, which randomly defaults the various obligors (the MFIs) and sovereigns based on their associated default rates, correlations and geographic locations.

The model also takes into account the amount of geographical diversification in the pool based on 20 regions. A concentration of MFIs in any given region will generally increase S&P's expected default rate for a transaction due to the likely increased correlation among defaults if the region experienced economic stress.

Meanwhile, the IFC aims to help governments and financial institutions find new ways to serve the poor in the Middle East and North Africa by looking at how Islamic finance could be used to support microfinance entrepreneurs. The subject was addressed at a workshop last week that brought together microfinance experts, government officials and Islamic finance specialists, who explored ways to address the challenges surrounding implementation of Sharia-compliant microfinance initiatives.

Islamic microfinance has an estimated global reach of only 380,000 customers and accounts for only about 0.5% of total microfinance outreach, according to a 2007 global survey by CGAP, which collected information on more than 125 institutions and contacted experts from 19 Islamic countries. The supply of Islamic microfinance is concentrated in a few countries - mainly Indonesia, Bangladesh and Afghanistan.

AC

CDS

Increased overlap

CDS CCP to lower barriers to entry

Analysts expect the introduction of a CDS central counterparty to lower the barriers to entry for cash market investors. But, as a number of exchanges prepare to launch index CDS clearing services, the approach for single name CDS remains unclear.

Alberto Gallo, US credit and credit derivatives strategist at Goldman Sachs, believes that stabilisation in the CDS market due to the introduction of a central counterparty should increase the overlap between the cash and synthetic investor bases. He suggests that, given the CDS spread of a counterparty has typically been wider than the CDS spread of the name that is to be hedged, one challenge for the industry is to refocus on CDS as a hedging instrument.

The basis between CDS and bonds has become more negative recently because cash investors have offloaded bonds, yet hedge funds - which had previously exploited the basis - can no longer buy them because of rising funding costs. At the same time, investors are reluctant to buy protection on CDS, given counterparty risk concerns.

Gallo continues: "However, a central counterparty should improve this situation, allowing real money investors to use CDS as a hedge; therefore, the amount of protection buying would increase. Margin requirements are likely to rise if a clearing house is introduced, which could nonetheless put a ceiling on spread levels." Higher initial margins would bring a CDS contract closer to a bond in funding terms, thereby decreasing the embedded leverage in the product and the appeal to protection sellers.

A number of exchanges on both sides of the Atlantic have indicated that they should have the necessary systems in place to begin clearing index CDS by the end of the year, with single name CDS following at a later date (see SCI passim). Tim Brunne, structured credit strategist at UniCredit, points out that a suitable margining system for single name CDS is more difficult to determine than for index CDS.

For example, a default event leads to much larger payments on the protection leg of the swap compared to index CDS, while the analytics for margin calls will have to model diversification in the counterparty's portfolio of single name CDS and hence must include some assumptions on default correlation. "The challenge is to estimate the gap risk of the clearing house appropriately and at the same time request margin calls from the counterparties that are not excessive, which would make central counterparty clearing from a financial institution's point of view uneconomic," explains Brunne.

Other features of single name CDS that complicate central clearing is their illiquidity and the fact that they are traded without upfront payments (except for distressed names), so the coupon of the premium leg is not fixed - and thus offsetting - like it is for index CDS. Only a few names are continuously traded with a liquidity that is sufficient to determine proper end-of-day quotes for all standard maturities.

"Presently, at least, Liffe tends to assume that fixed-coupon CDS will not be accepted by the market," notes Brunne. "A process may therefore be needed to clean up CDS positions with offsetting protection legs."

One such process that is understood to have been put forward involves restructuring existing annuities into two upfront contracts with standardised recovery rates and term structures, which would allow for multilateral netting and the ability to margin daily. Sources suggest that the consequent operational efficiency - and compression of bid/ask spreads - will reduce the CDS market's barrier to entry and facilitate increased transparency. In addition, a change in the prime broker business model is underway, which could see increasing numbers of banks facing exchanges as a clearer for smaller clients.

CS

Investors

Reshaping assumptions

Loan modifications to help stabilise the financial system?

A raft of new loan modification programmes is set to reshape investor/rating agency assumptions about US sub-prime RMBS cashflows (see last week's issue). However, the market remains divided over whether such measures will ultimately ameliorate the housing crisis and hence help stabilise the financial system.

First, the moral relationship between lenders and borrowers has to be reestablished, according to NewOak Capital ceo Ron D'Vari. "Through programmes such as the FHA's 'Hope for Homeowners' platform, the industry is advocating that borrowers go back on their contract to pay," he says. "But in order to bring liquidity back into the system, there needs to be confidence that all parties will behave as promised. Credit performance is a self-perpetuating phenomenon that feeds directly into home prices."

The FHA programme essentially asks lenders to take write-downs and borrowers to sacrifice future appreciation. But a number of alternative foreclosure mitigation strategies have been announced recently: Fannie Mae/Freddie Mac will reduce monthly payments to 38% of income for troubled borrowers; Citi will modify a further US$20bn of mortgages (on top of the US$35bn already modified since 2007); and JPMorgan will make payments easier on US$110bn of problem loans; while Bank of America has already modified 226,000 mortgages this year.

In addition, FDIC and the US Treasury are thought to be preparing a new loan modification framework designed to help two to three million borrowers. It is understood that under the plan lenders can modify loans to make them affordable and, following modification, the government would guarantee the lender against future losses (or a portion thereof) on the modified loan. As an incentive for lenders to perform modifications, the government could potentially also be prepared to cover up to half of the upfront loss amount.

The FDIC/Treasury programme aside, loan modification strategies are almost all limited to owner occupants and are largely aimed at tackling affordability problems, not issues of negative equity. Most programmes acknowledge that securitisation documents may limit their ability to perform some modifications and note the need to get investor permission in some cases.

Deutsche Bank securitisation research analyst Karen Weaver believes that the combined impact of these programmes is unlikely to be significant enough to change the course of the housing cycle. First, while programme architects increasingly speak in terms of performing 'systematic' or 'blanket' loan modifications, any loan modification plan that is not a social programme ultimately requires a loan-by-loan analysis. Another issue continues to be the fear of litigation by securitisation investors, but perhaps the biggest impediment is the difficulty of finding borrowers that are both willing and able to make a modified payment - particularly when faced with negative equity in their homes.

"Consequently, until there is a programme that significantly improves lender economics for performing modifications without jeopardising investor interests in securitisations, we continue to have very modest expectations for modifications to ameliorate the crisis. The FDIC/Treasury plan may address that, but the details remain to be seen," Weaver notes.

D'Vari agrees: "Given that there is little bondholder activism towards revising the documentation to allow efficient dealings with borrowers, the majority of RMBS aren't being taken care of. There is agreement that the banking system needs to be shored up, but at the centre of the system are borrowers - and nothing has trickled down to their level yet. Until this is solved, home prices are unlikely to turn around."

D'Vari suggests that the US government should also guarantee certain existing loans modified to fit the borrower's current financials, with participation in equity in exchange. "If the government guarantees existing or modified mortgages subject to commercially reasonable criteria, properties will be maintained and after five years homeowners and the government can both share in the profits, when the homes are sold or refinanced," he concludes. "To reduce the tax burden, government could also set terms with the holders of the mortgages to share the ultimate costs. This will help to slow down the abrupt delevering; in turn stabilise home prices and hence the financial system."

CS

Operations

Preparing to pounce

Infrastructure readied in expectation of asset price bottoms

Distressed asset prices are said to be nearing the bottom, as evidenced by the number of new investment funds preparing to enter this space within the next few months. However, industry calls for enhanced control and risk monitoring within structured finance portfolios means that asset managers will need to have the appropriate technology and infrastructure in place before doing so.

Doug Long, evp, business strategy at Principia Partners, says that the emergence of a number of new investment funds and signs from hedge funds that they are looking at this area suggests that asset prices have hit, or are close to hitting, the bottom. Pension funds and insurers are targeting long-term investments in this space via distressed debt funds, while some on-balance-sheet operations within banks - especially those that have more capital - are beefing up their operations in and exposure to the asset class.

"There is a wave of investors getting ready to invest in structured finance assets at distressed levels, but nobody is going to get a mandate to invest without the right controls and surveillance in place," Long notes.

According to one credit opportunity fund manager, the implementation of suitable technology is of the utmost importance for his fund, which invests in both corporate and structured credit assets. Meanwhile, industry policy groups - such as the Counterparty Risk Management Policy Group - have also highlighted the importance of increased control within structured finance portfolios, as well as enhancements to the risk monitoring and management of such on- and off-balance sheet exposures.

Principia is one vendor that has updated its offering in an attempt to address such demands, by introducing Principia SFP (Structured Finance Platform) Version 6. The offering is expected to be implemented by a range of organisations - managers within bank treasuries, off-balance sheet operations and investment funds, and especially those that have to quickly adapt themselves to the new environment.

"The industry bodies have given their recommendations, and now it is the responsibility of the banking organisations and service vendors to provide the suitable infrastructure. We are providing an operational backbone, but we need to see all sectors of the market acting together. This is key to giving organisations the ability to restore investor confidence," comments Long.

But not all market participants are convinced that structured finance asset prices have reached their ultimate lows. According to the credit opportunity fund manager: "I believe that asset prices reaching the bottom will be indicated by an uptick in transactions, both in the primary and secondary market."

He concludes that, while his fund has begun investing in distressed structured credit, his firm is in absolutely no rush to buy such assets.

AC

CDO structurer hired

The latest company and people moves

CDO structurer hired
DBRS has appointed Jerry van Koolbergen as svp in its structured credit group in New York. Van Koolbergen was previously an executive director at Morgan Stanley in CDO structuring & origination, having previously worked at JPMorgan as vp in a similar role. Glen Leppert has also joined the rating agency as vp within the structured credit group. Both started at the rating agency last week.

Structured credit sales head appointed
Bettina Mazzocchi, a former vp in structured credit sales at Morgan Stanley, is understood to have been hired as a remarketing account manager at PIMCO. Mazzocchi worked at Bank of America in the structured credit products group before joining Morgan Stanley.

Syndicate head moves on
Scott Wisenbaker, CDO syndicate head at Goldman Sachs in New York, is understood to have left the bank.

Credit fund future in doubt
The directors of GLG Credit Fund last week called an extraordinary general meeting of shareholders to vote on the termination and voluntary wind-up of the fund. Redemptions of shares in the fund were suspended with effect from 3 November due to adverse economic and fiscal changes affecting the fund. The fund will continue to calculate and publish a NAV per share.

CDO asset manager cuts headcount
CRE CDO asset manager Centerline has announced firm-wide staff reductions of approximately 20%. Fitch has downgraded its asset manager rating to CAM2 from CAM1-, reflecting the adverse impact of current market conditions on Centerline's business franchise and financial condition. Centerline has announced a plan to de-lever its balance sheet, which includes repaying US$68m of term debt due by the end of this year.

However, Fitch believes that staffing available to support Centerline's CDO management activities remains at an appropriate level. Fitch will continue to monitor Centerline's financial condition as it relates to the operational capacity of the company's CDO management function.

Monoline for sale?
Following rumours in the European press that Dexia is considering selling all or part of FSA, Dexia has confirmed that the mandate was given by its board of directors to the ceo on 20 October to explore the options and means which might enable the specific risk of FSA's activity to be reduced (see SCI issue 109). Decisions taken in this context will be the subject of a specific communication in due time, Dexia says.

Fitch and Numerix partner up
Fitch Solutions and NumeriX have announced a new partnership whereby NumeriX will launch a new data adapter that supports Fitch Solutions' consensus pricing data for corporate, sovereign, loan and asset-backed credit derivatives, as well as CDS indices information. As a result, NumeriX users will be able to leverage more credit data as they structure complex derivatives.

ICMA adds to regulatory policy team
The International Capital Market Association (ICMA) has appointed David Hiscock to its regulatory policy team as senior advisor. Prior to this appointment, Hiscock spent over twenty years at JPMorgan, where he had a variety of roles most recently as md and European head of hybrid capital structuring.

He joined the team, managed by ICMA's head of regulatory policy Paul Richards, at the beginning of November to co-ordinate ICMA's policy work on various initiatives undertaken on behalf of its members and the industry, particularly in response to current global market turbulence. In this context the focus is on ICMA's role in restoring the effective functioning of cross-border secondary markets through the application of its rules and recommendations on market practice.

Chief technology officer appointed
OTC Val has appointed Paul Bergbusch as chief technology officer, leading the effort to introduce the next generation of solutions further expanding the coverage for structured products and exotic derivatives under the firm's portfolio. He will be based in Vancouver and moves to OTC Val from BlueCrest Capital Management, where he was head quantitative analyst for the equity derivatives desk.

FRS Global makes acquisition
FRSGlobal has acquired regulatory reporting specialist BusinessObjects SECAM+ from Business Objects, an SAP company. The SECAM+ solution enables UK-based investment firms to meet regulatory reporting demands of the Basel Capital Accord, as stipulated by the Financial Services Authority. The acquisition strengthens FRSGlobal's strategic relationship with SAP, offering FinancialAnalytics as a core part of the SAP BankAnalyzer global solution.

Fund administrator hires
Butterfield Fulcrum Group, a fund administrator backed by 3i, has appointed Joost Löbler as md, business development for Europe, Middle East and Asia.

"Europe, Middle East and Asia will continue to be significant growth areas for alternative investments and asset management, and we are pleased to have such an experienced and knowledgeable business development director to tackle these regions," comments Akshaya Bhargava, ceo of Butterfield Fulcrum Group. "With our recently announced merger, Butterfield Fulcrum Group has both the resources and talent to become the leading fund administrator in these high growth markets."

Based in the firm's London office, Löbler will be responsible for overseeing the coordination and development of sales in Europe, Middle East and Asia. He brings 20 years' experience in global fund administration and investment banking to Butterfield Fulcrum Group, most recently working as md for Equity Fund Services, part of the Equity Trust Group.

IDC names future ceo
Interactive Data Corporation has appointed Raymond D'Arcy as president of sales and marketing for Interactive Data, succeeding Stuart Clark as the company's president and ceo upon Clark's planned retirement in 2009. D'Arcy has held a variety of executive roles during his 29 years with Interactive Data Corporation.

In his most recent role as president of Interactive Data's sales and marketing organisation, D'Arcy led the unification of Interactive Data's two largest institutional sales, account management and client service organisations, and played an instrumental role in refining and building the Interactive Data brand across the company's institutional services segment.

Asset manager ratings withdrawn
Fitch has withdrawn 10 of its CDO Asset Manager (CAM) ratings, predominantly across the leveraged loan, structured finance and commercial real estate asset classes.

The CAM rating withdrawals affect: Ares Management CAM2+, US leveraged loans; BlackRock Financial Management CAM1-, investment grade corporates; BlackRock CAM1-, structured finance; BlackRock CAM1-, US commercial real estate; BlackRock Financial Management CAM2, European commercial real estate; Hartford Investment Management Co. CAM2+, US leveraged loans; Lyon Capital Management CAM2-, US leveraged loans; PIMCO CAM1-, investment grade corporates; PIMCO CAM2+, US leveraged loans; PIMCO CAM2, structured finance; PPM America CAM1-, US leveraged loans.

Mortgage finance team expanded
Deutsche Bank has appointed a number of ex-Lehman staff for its mortgage finance sector coverage. William Curley and Anthony Viscardi have joined the firm's global banking division as mds in the financial institutions group (FIG) based in New York.

At Lehman, Curley was md and head of the firm's mortgage banking advisory practice. He has over 19 years of investment banking experience and was the founding member of Cohane Rafferty Securities, a boutique investment banking firm dedicated to advisory mergers and acquisitions in the mortgage banking sector which was acquired by Lehman in 2002. Viscardi was an md in the financial institutions group at Lehman, with responsibility for coverage in the non-bank finance sector.

In addition, Deutsche Bank has hired several other FIG specialists from Lehman Brothers, all of whom will be based in New York. The additional team members include Matthew Monahan, who joins as a director and was previously a svp in Lehman's structured asset solutions group, having worked closely with Curley at Cohane Rafferty.

Peter Salwin also joins as a vp, working with the FIG team in both specialty and mortgage finance. Prior to joining Deutsche Bank, Salwin worked in Lehman's FIG since joining as an analyst in 2000.

Finally, Daniel Zimbaldi joins as a vp, focusing on the mortgage finance sector, while Brendan Sheldon joins as an associate and will work across both the specialty and mortgage finance sectors.

Navigant appoints head of restructuring team
Navigant Consulting, a consulting firm providing dispute, investigative and operational risk management and financial advisory solutions, has hired Mitchell Kaye as md. Kaye will lead the newly created financial institutions restructuring solutions team (FIRST) on behalf of Navigant Capital Advisors (NCA), the corporate finance business unit of Navigant Consulting. The team will provide a full suite of services to stressed and distressed financial institutions.

Prior to joining Navigant Consulting, Kaye was founder and ceo of Belhaven Partners, a hedge fund restructuring boutique. Belhaven provided liquidity and advisory services to hedge funds and hedge fund investors. Before founding Belhaven, Kaye was the ceo of two asset management firms: Xmark Asset Management, which he founded in 2001 and ran until 2007; and Brown Simpson Asset Management, which he co-founded in 1995 and ran until 2001.

The FIRST service offering is designed to provide: investor/manager oversight; portfolio valuation and assessment; counterparty and creditor work-out support; institutional sales solutions; sales, transfers and novation of OTC derivatives; and general corporate strategic advisory.

AC

Insurer outlines securitisation plan

A round up of this week's structured credit news

Insurer outlines securitisation plan
AIG is set to become the first insurer to take advantage of the TARP, after announcing details of its amended rescue package. The US Treasury will invest in US$40bn of the insurer's preferred stock through the TARP, while the Federal Reserve Bank of New York and AIG will set up two SPVs (capitalised by the Fed) to clean up its balance sheet.

One of the SPVs will purchase, for cash, certain assets from AIG related to its securities lending programme that have experienced significant declines in market value. The other SPV is intended to purchase reference obligations from counterparties to AIG Financial Product's multi-sector CDO portfolio of CDS contracts in exchange for a commutation of the CDS contracts, thus eliminating the contracts' potential collateral and capital needs.

According to Fitch, a successful completion of these securitisation transactions will materially reduce the liquidity needs and capital drains derived from AIG's securities lending programme and AIGFP's multi-sector CDO CDS portfolio, which in recent months have resulted in substantial uses of liquidity provided by the Fed Facility.

The rating agency also suggests that segments of AIGFP's portfolio of CDS contracts that are not part of the AIGFP securitisation plan could generate material cash and/or capital needs under various scenarios. At 30 June, the notional value of the portfolio - excluding the multi-sector CDO portfolio - totalled US$366bn.

CDS execution enhanced
Tradeweb has developed enhanced marketplaces in the US and Europe where clients will be able to view real-time composite prices and efficiently execute and process trades for the major CDS indices. The US market is live, while the European version is expected to launch in January 2009. The firm says that the initiative supports the goals voiced by financial regulators in recent weeks by providing increased price transparency, a marketplace for electronic trading and connectivity to relevant third parties for electronic processing, and legal confirmation of CDS index trades.

The new marketplaces will benefit institutional clients by:

• Providing access to the liquidity of leading CDS dealers;
• Displaying real-time indicative composite two-way pricing for the major US and European CDS indices;
• Providing connectivity to key third parties, including DTCC Deriv/SERV (and the Trade Information Warehouse), and order management systems where relevant;
• Maintaining a full audit trail on all trades;
• Electronically capturing trade details in real-time, using the Tradeweb API messaging service;
• Providing access to AccountNet, Tradeweb's leading derivatives account database to maintain accurate settlement instructions and deliver electronic allocations to dealers.

The markets will provide a new trading protocol, 'Request-for-Market', in addition to enhanced 'Request-for-Quote' functionality, pioneered by Tradeweb in the late-1990s. RFM allows a client to request a two-sided market and negotiate interactively with a single dealer, while RFQ allows clients to request a price from up to four dealers simultaneously.

Moody's downgrades Ambac and MBIA
Moody's has downgraded Ambac's insurance financial strength rating (IFSR) to Baa1 from Aa3 and the holding company's senior unsecured debt rating to Ba1 from A3, following the company's weaker-than-expected results. The agency has also downgraded to Baa1 from A2 the insurance financial strength rating of MBIA and its supported insurance companies, concluding a review for possible downgrade that was initiated on 18 September 2008.

The action reflects Moody's view of the monolines' diminished business and financial profile resulting from its exposure to losses from US mortgage risks and disruption in the financial guaranty business more broadly. The outlook for the ratings is developing.

The downgrades result from four primary factors. First is Moody's expectation of greater losses on mortgage related exposure, reflecting continued adverse delinquency trends.

Second is the possibility of even greater than expected losses in extreme stress scenarios, with losses possibly reaching sectors beyond mortgage-related exposures as corporate and other consumer credits face a more challenging economic environment. Third is Moody's view of the monolines' diminished business prospects as reflected in their substantially reduced participation in the primary financial guaranty market in 2008. Finally, fourth is the companies' limited financial flexibility.

In its Q308 earnings release, MBIA reported increased case loss reserves of US$961m related to direct RMBS exposures and US$66m in credit-related impairments on CDS referencing ABS CDOs. The company's loss reserves on direct insured RMBS exposures are now broadly consistent with Moody's revised expectations, while MBIA's credit-related impairments on ABS CDOs are approximately US$1.5bn below Moody's current expectations. The increase in loss reserves has adversely affected the firm's regulatory capital; at Q308, MBIA's policyholders' surplus was approximately US$3.3bn and contingency reserves were approximately US$2.9bn.

Meanwhile, Ambac reported Q308 losses of US$608m on financial guarantee policies (mainly on RMBS exposures) and US$2.5bn of impairments on CDS on ABS CDOs.

Moody's states that the developing outlook on the two monolines' ratings reflects both the potential for further deterioration in the insured portfolio as well as positive developments that could occur over the near to medium term, including greater visibility about mortgage performance, the possibility of commutations or terminations of certain ABS CDO exposures and/or successful remediation efforts on poorly performing RMBS transactions, as well as the potential for various initiatives being pursued at the US federal level to mitigate the rising trend of mortgage loan defaults.

Auction results in for Icelandic banks ...
Creditex and Markit, in partnership with 14 major credit derivative dealers, have announced the results of credit event auctions that determined a price to facilitate the settlement of credit derivative trades referencing the senior and subordinated debt of Kaupthing Bank and Glitnir. The final price for Kaupthing senior debt was determined to be 6.625%, and 2.375% for the subordinated debt. In the case of Glitnir, the senior debt was determined to be 3%, and the subordinated debt 0.125%.

... while DTCC completes WaMu processing
The DTCC's Trade Information Warehouse has completed the automated credit event processing and settlement of Washington Mutual CDS contracts. Approximately US$1.4bn in net funds were transferred from net sellers of protection to net buyers of protection.

The net funds transfer covered outstanding WaMu single name CDS, as well as CDS index contracts and tranches in which WaMu was a component. WaMu was a component in approximately 35 indices serviced by the Warehouse, with component percentages ranging from 0.80% to 4.17%. As of 23 October, the gross notional value of outstanding single name CDS for WaMu registered in the Warehouse stood at US$41bn.

Primus listing standard questioned ...
Primus Guaranty has been notified by NYSE Regulation that it is not in compliance with one of the continued listing standards of the New York Stock Exchange. The company is considered below criteria established by the NYSE because its total market capitalisation has been less than US$75m over a consecutive 30 trading-day period and its last reported shareholders' equity was less than US$75m. In accordance with exchange procedures, Primus says it intends to provide the NYSE with a business plan that outlines the definitive action it has taken, or proposes to take, in order to bring it into compliance with its continued listing standards within 18 months of receipt of the notification.

If the average closing price of the company's common shares is less than US$1 over a consecutive 30 trading-day period, it will also receive a formal written notice from the NYSE regarding its non-compliance with an additional NYSE listing standard. As of 6 November, the average closing price of the company's common shares over the last 30 consecutive trading days was US$1.20 and the closing price of the company's common shares on 6 November was US$0.64. Primus believes it will be out of compliance with this additional listing standard, unless the market price of its common shares increases significantly in the near term.

... while CDPC counterparty ...
Moody's has withdrawn its counterparty ratings for Aladdin Financial Products at the request of the issuer. The issuer has requested the withdrawal of ratings for business reasons.

The agency has also withdrawn the provisional counterparty rating of (P)Aaa assigned to 47 Quay Ltd, as well as the provisional debt ratings of (P)Aaa assigned to the Class A-1, (P)Aa2 assigned to the Class B-1 and (P)A2 assigned to the Class C-1 of 47 Quay Capital Ltd. The CDPC has confirmed to Moody's that it has abandoned its planned launch due to prevailing adverse market conditions, but has indicated that this decision may be revisited in the future if market conditions improve.

... and auction note ratings withdrawn
Moody's has withdrawn its provisional ratings on the US$100m triple-A rated Class A auction notes that Channel Capital intended to issue. The agency says the ratings were withdrawn because Channel no longer intends to issue the notes. The rating action does not affect the current Moody's counterparty rating or other notes' ratings assigned to Channel.

US CDOs/RMBS lead Q3 downgrades
Fitch says that rating actions by the agency for global structured finance transactions during Q308 continued to be concentrated in downgrades amongst US RMBS, as well as US CDOs. In its quarterly rating review of global SF deals, the agency also noted that newly-rated issuance declined further globally in Q308 compared to the previous quarter.

"Continuing house price declines in the US have seen performance issues that started in sub-prime move onto impact the Alt-A sector and ultimately prime," says Glenn Costello, md and US SF risk officer at Fitch. "Alt-A and prime RMBS transactions therefore represented a large proportion of downgrades in the quarter, with a revised surveillance rating process being adopted for prime. Weak RMBS performance again fed through to CDO downgrades being dominated by structured finance CDOs."

Fitch-rated US structured finance issuance increased by 12.3% in Q208 to US$58.6bn from its Q108 low, but remained at historical lows due to the ongoing credit crisis. The increase was driven exclusively by core non-mortgage US ABS, with other asset classes remaining largely unchanged on the previous quarter.

There was an apparent bounce-back in EMEA SF issuance in Q208 to pre-crisis levels, as volume rose 269.9% from Q108 to US$209bn. However, Stuart Jennings, md and EMEA SF risk officer at Fitch cautions: "This issuance surge did not mark a sudden return of investor confidence to the market, but almost exclusively consisted of bank issuer-retained RMBS transactions for potential use as collateral for repo funding with the European Central Bank, as well as the Bank of England's Special Liquidity Scheme."

In the Asia-Pacific region, deteriorating performance saw some non-conforming RMBS transactions downgraded in both Australia and New Zealand. The deteriorating credit profile of mortgage insurers also had an impact upon the Australian RMBS sector in particular. Mortgage insurance dominates in Australian RMBS and the continuing rating watch negative position of Genworth and MGIC saw a number of tranches placed on RWN at the end of the quarter.

Do rating agencies really add value?
A new research paper from the Cass Business School, sponsored by F&C, concludes that - despite recent fierce criticism from some quarters - credit rating agencies (CRAs) do add value to the financial services industry. The study concentrated on rating events for investment grade European banks between January 2005 and June 2008. To asses the timeliness of the CRA action, the research used the performance of two market indicators - CDS and share prices.

It found evidence of stocks and CDS spreads showing abnormal changes before positive and negative rating changes, suggesting there is a significant - and therefore detrimental - delay between the market indicator changes and CRA action. However, the author argues that rating changes cause a 'ripple effect' that can generate further abnormal market indicator changes after the ratings event.

This can be enhanced by the publication of new information, such as press releases. It cannot therefore be concluded that CRAs did not provide any value to the market, the report states.

Report says structured credit here to stay
A new report entitled 'Market Updates and Investment Trends: Where the Money Is Going' from financial research and consulting firm Celent examines how the main asset classes and investor pools have responded to the unfolding crisis and what the future holds for them. According to the report, all asset classes will remain on the table post-crisis, but demand for new, complex structured products will be limited. Instead, the dominant theme is the right asset for the right investor, with an investment structure tailored to the underlying liquidity situation and investor's time horizons.

The credit crisis does not spell the end for the structured credit and securitisation market, the Celent report says. The shape of these markets is likely to change, however: they will be smaller and use simpler structures, but will remain significant.

The report also focuses on CDS, saying that - while OTC markets are likely to take a back seat to listed derivatives in the near future - Celent believes that both markets will coexist in the long term because they cater to different needs and different players. Due to heightened regulatory pressure, however, the migration of some OTC market activity to central clearinghouses and ultimately to official exchange platforms will gain momentum.

"Demand for new assets is strong, driven by the search for value and uncorrelated returns," the report continues. "Yet new assets must be viewed individually because the term encompasses markets at vastly different stages of the development cycle in terms of their available supply and market development."

Celent says distressed debt and infrastructure are believed to be at the forefront of emerging assets as a result of ample supply and heightened interest among a wider range of players. "Niche assets, such as freight, microfinance, longevity, and reverse mortgages, will be bought by natural participants, hedgers, hedge funds and a subset of institutions looking for diversification," it concludes.

TARP examined
Five financial trade associations have unveiled an industry survey that examined more than 400 firms' views of participation in the TARP.

According to the survey:

• Large firms are more likely to participate in the programme
• Institutions will prioritise the purchase of sub-prime and Alt-A residential real estate, followed by commercial real estate, particularly for smaller institutions
• Firms believe whole loans and securities should get roughly equal prioritisation
• Firms disclosed that 50%-60% of their assets are residential related, and those assets comprise both whole loans and securities
• Institutions would sell approximately 50% of their assets targeted for TARP at a slight discount to model-based valuations (or current book value if marked to market), but small institutions would require prices closer to cost
• Larger institutions identified corporate loans and CDOs as having the greatest illiquidity premium and would be the most beneficial to their institutions if purchased by TARP.

S&P further revises correlation assumptions
S&P has revised certain correlation assumptions that it uses to rate CDOs and CDS that have exposure to insurance companies, real estate investment trusts (REITs) and real estate operating companies (REOCs).

The revised assumptions relating to insurance companies were developed jointly between the agency's insurance and structured finance CDO groups, after they evaluated the characteristics and expected performance of the institutions operating in the insurance industry. These changes reflect S&P's views on the expected behaviour of the different insurance sectors and incorporate the recently observed greater interdependence among certain insurance sectors over the past few months.

For purposes of S&P's correlation assumptions, it will no longer classify the insurance industry as a single, monotonic regional industry because the agency believes that the various segments of the insurance industry have different business objectives and investment horizons and react to different economic drivers. Therefore, S&P will now differentiate the companies operating in the insurance industry based on their core business objective, asset and investment characteristics, geographic reach and most recent observed behaviour. Using these differentiating factors, the agency has reclassified insurance companies into the following categories: property and casualty, health, life, and diversified.

The new insurance industry classifications assume that these entities are affected by regional changes in the economic environment and, in some insurance sectors, by global changes. Accordingly, these modifications may, in some cases, reduce or even eliminate some of the benefits due to the geographic diversification of insurance companies for CDOs and CDS that include insurance companies. However, by having more insurance industry categories, diversification benefits may be obtained when different insurance company sectors are included in these transactions.

S&P has tested these new assumptions on a number of transactions that are exposed to insurance companies and its analysis of those transactions suggests that these changes will likely have little effect on existing ratings. However, specific transactions may show different results depending on the number, type and regional diversification of the insurance companies to which they are exposed. In particular, transactions with very high concentrations in insurance assets, such as hybrid debt securitisations, are likely to be negatively impacted by these changes.

Meanwhile, the revised assumptions related to REITs and REOCs were developed jointly between S&P's commercial real estate and structured finance CDO groups, after they evaluated the characteristics and expected performance of the institutions operating in the real estate industry. The changes reflect the agency's views on the expected behaviour of the different real estate sectors.

For purposes of S&P's probability of default and correlation assumptions, it will no longer classify REITs and REOCs as asset-backed issuers, but rather as corporate issuers. The agency will also differentiate between mortgage REITs and equity REITs: mortgage REITs are generally defined as REITs that focus primarily on real estate financing, while equity REITS are generally defined as REITS that invest mainly in real estate equity.

Going forward, when S&P rates CDOs or CDS, it will use the corporate probability of default table in CDO Evaluator to estimate the likelihood of default or deferral for any REIT or REOC. This change will likely increase the amount of defaults or deferrals that we expect for REITs or REOCs of any given rating and tenor.

The correlation changes generally assume that mortgage and equity REITs and REOCs are affected by regional changes in the economic environment and, in the case of mortgage REITs, by global changes. Accordingly, these changes are expected to increase the assumed correlation affecting mortgage REITs and reduce the assumed correlation affecting equity REITs and REOCs in S&P's analysis of CDOs and CDS.

When taken in aggregate for the given current rating categories, these changes are likely to lead to higher credit enhancement levels for certain transactions exposed to REITs and REOCs, particularly securitisations of hybrid assets issued by REITs and REOCs. These changes will be reflected in the industry codes and correlation assumptions that S&P uses in its CDO Evaluator.

CLO collateral managers scrutinised
The positive and negative traits of the collateral manager servicing a CLO transaction may influence its credit quality and ratings, says Moody's in a new report.

"Collateral managers perform numerous functions and serve different, sometimes conflicting, constituents within a single transaction," says Moody's vp Lina Kharnak, the author of the report. "In effect, both the collateral manager's core competencies as well as attitude towards CLO management may have an impact on Moody's ratings."

The most important attributes Moody's looks at include the manager's experience and how appropriate it is for the CLO, what type of instruments the manager may trade in and how tightly aligned the manager's interests are with those of the equity investors.

The report states that having a manager with a substantial equity stake in a transaction can have a positive impact on performance, as it gives the manager additional incentive to avoid losses from the outset. However, says Moody's, the interests of equity and debt investors may diverge if the portfolio deteriorates and the manager is under pressure to continue generating equity returns.

Moody's acknowledges that collateral managers require a degree of flexibility in managing their portfolio. However, some managers have taken a 'kitchen sink' approach to structuring transactions, which the agency sees as incompatible with CLOs, which are highly structured investment vehicles. Moody's views a collateral manager being willing to operate under a strong collateral management agreement as a positive trait.

AIG linkage assessed
Moody's is assessing the impact of linkage to AIG on the ratings of all structured finance transactions that have exposure to the insurer as guarantor in relation to one or more swap agreements. The senior debt obligations of AIG are rated A3/Prime-1 by the rating agency, but are currently on review for possible downgrade. According to Moody's published criteria, the risk of default by a guarantor in relation to swap payments is substantially de-linked from structured finance transactions, provided that the swap counterparty is required to take suitable remedial action following a downgrade of the guarantor below certain rating thresholds and the performance of such remedial action is irrevocably guaranteed by the guarantor. Typically, the remedial action involves posting collateral and, upon downgrade of the guarantor below A3/Prime-2, using reasonable efforts to transfer the counterparty's rights and obligations to (or obtain a guarantee from) a suitably rated third party.

The counterparties under the swap agreements are subsidiaries of AIG, with the swap agreements providing for remedial action to be taken by the swap counterparties by reference to the ratings of AIG. The recent rating actions in respect of AIG have already triggered obligations to post collateral under certain swap agreements. Moody's understands that the swap counterparties intend to perform these obligations and are currently posting collateral under the relevant swap agreements for which credit support annexes are in place.

However, the likelihood that the swap counterparties' obligations to take remedial action will continue to be performed depends, in part, on whether such obligations are guaranteed by AIG. Although the swap counterparties are rated by Moody's, their ratings are primarily based on general parent guarantees pursuant to which AIG guarantees the 'monetary' obligations owed by the swap counterparties to third parties. AIG also provides a separate guarantee for each swap agreement that covers 'payment' obligations owed by the relevant swap counterparty.

Desire for regulatory consolidation highlighted
As G20 leaders prepare to convene in Washington this weekend, the global business community acknowledges and accepts that - in the wake of the current global financial crisis - there is a need for better regulation of markets and a strong desire for a restructuring and consolidation of regulatory bodies, according to a survey published by Allen & Overy.

Highlights from the survey include:

• Global agreement on the need for increased regulation of hedge funds, ratings agencies, and securitisations and other structured finance products
• Overwhelming support for restructuring and/or consolidation of domestic regulators
• Global community split over need for establishment of a supra-national regulator to oversee global financial institutions
• No desire for any increase in FX/country exchange controls to limit flows of capital
• Strong agreement that short selling should not be prohibited.

Despite this, there is no overwhelming desire for a global regulator, with the market split on this point (42% agree and 50% disagree), and participants indicating that such a development would be unworkable and unachievable.

The study of over 700 business leaders from around the world - ranging from ceos and chairmen to general counsels, partners and directors - found that, while there is a near universal recognition of the need for better regulation, there is confusion and conflicting views as to how this might be delivered. There are also conflicting regional views, highlighting that solutions to this global issue may be difficult to identify and implement.

Wim Dejonghe, Allen & Overy managing partner, comments: "This survey is intended to provide a catalyst for debate. World leaders are preparing to gather to discuss the future of global financial regulation later this week but businesses are still reeling from the impact of recent events - they are yet to focus on how better to regulate the markets. We fear that, in the absence of an informed debate that fully engages market participants, we could face a knee-jerk political reaction that is focused on punishing the markets instead of helping them to function efficiently and securely."

Over three-quarters (76%) of respondents globally agree that greater regulation of rating agencies is necessary. This was felt most strongly by respondents in Asia (86%) and the US (84%).

Likewise there was strong support for greater regulation of hedge funds, with 66% of respondents agreeing. However, almost exactly the same proportion (67%) of respondents disagree that short-selling - an activity largely associated with hedge funds - should be prohibited.

Comments provided by those who took part in the survey also highlight the reality that many of the issues are not as straight forward as simply banning certain activities or increasing regulation of others, underlining the need for a careful and considered response to the current crisis by governments and regulators. Many comments provided by respondents also call for better resourcing of regulators, including better pay and more high-quality staff who understand how complex modern financial markets work.

Widening projected for bond insurer losses
Bond insurers' projected losses have widened in non-prime and second-lien RMBS and related ABS CDOs, according to a new S&P report. "The capital resources of these current and former triple-A rated primary bond insurers have been greatly pressured by the deteriorating performance of these asset classes," says S&P credit analyst Robert Green.

Since the agency's analysis of the bond insurers' exposure to non-prime mortgages and second-lien transactions in the 2005-2007 vintages on 19 December 2007, loss projections have worsened, the report notes. For instance, the projected losses for Alt-A, sub-prime, closed-end second and home equity line of credit transactions in the 2007 vintage were 13.3%, 27%, 55.2% and 37.9% respectively, as of 20 October 2008.

This compares with projected losses of 3.5%, 18%, 40% and 13% respectively on 19 December 2007. The higher cumulative net loss assumptions reflect subsequently higher delinquencies and foreclosures and the expectation for home pricing depreciation beyond what was initially anticipated, the report says.

EC establishes clearing roadmap
Industry and regulator representatives attended a meeting chaired by the European Commission last week to set a clear roadmap on how to ensure that CDS are cleared through a central clearing counterparty by the end of the year (see also separate news story). Participants agreed that technical work should proceed in sub-groups to deal with issues such as which CDS types would be cleared by when, which standards should apply to central clearing counterparties to ensure their robustness, how to ensure coherence with similar work taking place in the US, how to deal with price reporting, and how to ensure adequate information and supervision by regulators.

Permacap posts further dividends
As at the close of business on 31 October 2008, the unaudited net asset value per share of permacap Carador was €0.5927. The vehicle's NAV decreased by €0.0592 or 8.76% during the month. However, this decrease includes the dividend of €0.0550 (equivalent to 8.47% of September NAV) in respect of the six-month interim period paid on 31 October 2008.

This month's calculations include an estimated €559,452.19 worth of net cash flow interest received in the month (to be allocated between capital and income), which equates to €0.0112 per share.

Continued increase in CRE CDO delinquencies
Fourteen new delinquent loans led to the fourth straight monthly increase in the US commercial real estate loan (CREL) CDO delinquency rate to 3.13% for October 2008, from 2.39% for September 2008, according to the latest CREL CDO Delinquency Index from Fitch. Refinancing to third parties remains difficult, with nearly 90% of all new delinquencies this month considered matured balloon loans. Overall, 67% of the CREL DI consists of this type of delinquency.

While 74% of matured balloon loans continue to make monthly payments, approximately 26% (18% of CREL DI) are considered non-performing with inadequate cashflow to meet debt service obligations. In these cases, sponsors have refused or are unable to infuse additional equity into the projects.

Asset managers continue to report loan extensions. In line with last month's total, asset managers reported 35 new loan extensions in October (3% by number of loans in the CREL CDO universe); at least 75% were extensions that were contemplated in the original loan documents.

"Borrowers continue to be challenged to meet all extension requirements by loan maturity," says Fitch senior director Karen Trebach. "The increase in matured balloons this month reflects that the extension process is taking longer both to negotiate and document." Three loans, representing 25bp, fell out of the CREL DI as the extensions were successfully executed prior to this month's reporting cutoff date.

Asset managers continue to repurchase assets out at par to manage the credit quality of their pools. In October, three mezzanine loans (4bp) were repurchased; this rate compares to an average of 14bp of monthly repurchases over the past year. These affiliated loans from the same CDO were repurchased to allow for a restructuring of the mezzanine debt to accommodate new sponsorship.

Asset managers have also traded some delinquent loans out of CDOs at a loss, including a foreclosed loan and a 90+ days delinquent loan, both of which appeared in last month's CREL DI. The foreclosed loan was traded out at 84.7% of the loan amount, while the 90+ days delinquent loan was traded out at a complete loss. Furthermore, some asset managers have sold some CDO assets to third parties at below par, thereby removing assets that were not yet deemed impaired by the trustee and realising losses.

Future for OTC markets explored
Inter-dealer broker ICAP has published a white paper on the future of the OTC markets. The study argues that the global wholesale OTC markets are critical to the worldwide financial system and that their effective functioning is essential for the free flow and availability of capital, the mitigation of risk and investor choice. While there have already been significant investments in developing OTC market infrastructure, ICAP argues that this existing infrastructure needs to be further developed and used more efficiently for the benefit of all.

The white paper's recommendations include:

• Wider adoption of electronic trading - electronic trading creates greater price transparency, enables simpler and faster trade capture, affirmation and confirmation and easier supervision of trading activity.
• Quicker settlement cycles in all securities markets - a T+1 settlement cycle for all securities markets should be mandated.
• Faster and automated affirmation/confirmation of all derivatives trades - the affirmation and confirmation of all OTC trades in all markets needs to be automated and accelerated as close as possible to the trade date.
• Greater use of pre-booking netting - in many cases, transactions can legally and economically be netted, rather than settled on a gross basis.
• Wider adoption of central counterparty (CCP) give-up and/or central clearing for OTC derivative markets - those markets that do not already operate a central counterparty should introduce a CCP/clearing house that is independent of the trading platforms for those markets.
• Wider adoption of portfolio reconciliation - more regular and comprehensive reconciliation of OTC trade details and valuations between counterparties should be mandated.
• Wider adoption of portfolio compression in derivatives markets - more regular and comprehensive compression of derivative portfolios, ideally on a multi-lateral basis.

Methodology modified for wrapped securities
Moody's is modifying the rating methodology it applies to structured finance securities wrapped by financial guarantors. If a structured finance security is wrapped by a financial guarantor, the Moody's rating will be the higher of: the guarantor's financial strength rating; and the current underlying rating (i.e. absent consideration of the guaranty) on the security, regardless of whether the underlying rating is published or not. If the agency is unable to determine the underlying rating or an issuer has requested that the guaranty constitute the sole credit consideration, the wrapped security will take the rating of the financial guarantor.

Moody's plans to complete the majority of the review of all wrapped structured security ratings under this modified approach within approximately 60 days.
Its previous approach was to rate to: the higher of the guarantor's financial strength rating; and any published underlying rating.

In the event of a downgrade of a financial guarantor below investment grade, Moody's approach would have withdrawn the rating on an instrument that did not have a published underlying rating. To date, no rating has been withdrawn under this approach, as the agency has been working with issuers to publish their underlying ratings.

Misys releases monitoring solution
Application software and services company Misys has launched Eagleye V3.5 to help prevent losses, boost operational efficiency and prevent breaches of risk policies. The offering includes a new monitoring solution that can be called by front-office applications to conduct pre-deal checks and 'what-if' analyses, strengthening firms' ability to create preventative or predictive controls. The latest version builds on proven tools which help define, evaluate, monitor, alert, report and manage exceptions to business definable rules based on any data.

Misys estimates that on average firms spend between 15%-20% of their total operating costs on monitoring and control processes, but much of this is wasted as many still face severe problems when it comes to monitoring risks effectively. The Eagleye solution helps mitigate operational risks associated with running multiple monitoring functions and reduces manual processes that are heavily reliant on the use of spreadsheets by conducting monitoring proactively and automatically across the whole business on a single platform. It also provides firms with a platform to effectively monitor compliance with internal risk policies and obligations to existing and new regulations.

Chris Leong, operations director for Misys Eagleye, comments: "With new tough regulations imminent, the question is: how will financial institutions respond to the monitoring and control challenge? Without question, transparency and better traceability, reduced costs in monitoring and controls, and increased agility when it comes to meeting regulatory demands will all be key. Essentially this solution is all about reducing latency and getting the right information to the right person at the right time."

AC & CS

Trading ideas: dark matter

Dave Klein senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Anadarko Petroleum Corp

Anadarko Petroleum (APC)'s CDS rallied significantly before last week's earnings announcement. Its equity, while off recent lows, has failed to keep pace.

Both our directional credit model and our CSA model point to a widening of APC CDS and a share rally. Additionally, we believe APC implied volatility is too high. Given our expectation of a short-term equity outperformance, now is an excellent time to buy CDS protection and sell 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 equity share price 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, APC's equity has underperformed its CDS and now APC equity trades well below our modeled fair value. APC CDS also trades below its expected level according to our directional credit (MFCI) model, but this modelled level has not yet taken last week's earnings announcement into account.

Exhibit 2 charts APC market and fair CDS levels (y-axis) versus share prices (x-axis). The green square indicates our expected fair value for both CDS and share prices 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 CDS, with implied vol set to fair value. With CDS too tight compared to equity, we expect a combination of equity rising and CDS widening.

Risk analysis
The main trade risk is the company 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.

Continued credit improvement: Since we are selling equity options, our potential upside on the equity leg of the trade is fixed by the option price. If CDS levels tighten enough, the trade will lose money.

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 equity and CDS markets drives any trade. Our data on liquidity, created from the volume of bids, offers and trades that we see each day, reassure our trading in APC. APC is a reasonably liquid name and CDS bid-offer spreads are around 10bp.

Buy US$10m notional Anadarko Petroleum Corp 5-Year CDS at 130bp.

Sell 420 lots Anadarko Petroleum Corp US$30.00 Strike Jan 09 Puts at US$3.20 (100 multiplier per contract) to pay 130bp 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).