Contents

Operations

Valuation interpretation

Transparent assumptions are first step to deciphering prices

Various sectors of the market have taken the opportunity over the past week to fight securitisation's corner, re-emphasising that its revival is needed to get the wider credit sector back on its feet. The pricing of complex assets remains one of the main hurdles to overcome before restarting the securitisation process, but some structured credit practitioners believe that valuation is possible - provided that a number of factors are taken into consideration.

Making the assumptions behind asset valuations more transparent is a key step to aiding the structured finance market, argues Mike Thomson, md of the market, credit and risk strategies (MCRS) group at S&P. He says that an inability to value and understand structured assets has led to many good assets being sold unnecessarily.

The MCRS group illustrates the point by suggesting that 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 number of factors need to be taken into consideration when deciphering the value of an instrument," says Thompson, "and most important are the assumptions that go into the valuations. Many may not agree with those assumption inputs, but at least they know where you are coming from when you give a value for an asset."

He continues: "Nobody is going to disagree that we are in a broken market. But it is possible to construct a well-grounded valuation, based on the intrinsic value of cashflows for any kind of structured asset."

Credit strategists at Citi have, meanwhile, put forward what they consider as the six actions necessary to restart the securitisation market. They are: clean up the system; restore ratings credibility; bolster securitised product structures; simplify and create transparent products; address regulatory and accounting uncertainty; and restore demand.

"Given the market disarray, if securitisation is to be a viable funding tool, it now needs regulatory assistance," say the strategists. "We expect the regulatory actions will address the roots of the current securitised markets' problems, rather than over-regulate securitisation and make a potentially viable funding source uneconomical for issuers."

The strategists note that, with spreads at all-time wides, securitisation is non-competitive with simple balance sheet lending - meaning that many would attempt to convert the roughly US$8trn in outstanding securitisation to balance sheet funding. "Given the magnitude of the funding requirement and the scope of credit risk, we see this balance sheet approach as simply impossible without assistance from the existing securitised markets infrastructure that is available. Specifically, we believe that the stable credit nature and the diversification available via single-level securitised products is necessary to fund current economic requirements, which eventually will hopefully make them economic," they add.

One structured credit lawyer agrees that low leverage, simple capital structures and long-dated maturities are all recognised as being key to restarting the market; the only question remains pricing. "Some level of bank refinancing is a necessary first step as a comparison point," he concludes. "Inevitably, when banks begin lending again, their assumptions will be conservative and so securitisation should be able to offer a competitive price."

AC

Real Estate

Commercial innovation

New CRE-related structures pitched

Falling commercial property values have begun to impact European CMBS and CRE CDO transactions. However, innovation in the sector hasn't completely disappeared: certain investment banks are understood to be pitching new CMBS-related structures to liability-driven investors, such as pension funds.

"Traditionally, investment banks haven't had to focus on such accounts because there have been so many other types of investors around, but now they need to find new investors. Rent review clauses in commercial property leases tend to be inflation-linked and so there is a natural fit between these assets and the needs of liability-driven investors," Conor Downey, partner at Cadwalader, Wickersham & Taft suggests.

One such structure is believed to involve pooling several triple-A rated CMBS assets on a cross-collateralised low-LTV basis and then selling interests in the vehicle via securitisation. The structure could also prove to be a useful tool for refinancing existing deals, though it would typically only take down relatively low percentages of exiting CMBS transactions.

Downey predicts that in the future the market will also see more whole business-type or sale-and-leaseback deals, providing investors with access to tangible assets, names that they recognise and businesses that are understandable. "Strong corporates, for example, are likely to be attracted to such securitisation technology because the ability to raise finance elsewhere will be limited," he notes.

Meanwhile, falling commercial property values have begun to impact the European CMBS market, with six €1bn-equivalent transactions to-date experiencing loan-level defaults due to a variety of borrower-related issues and, in particular, breaches of financial covenants. In the last few months it has become clear that property values are unlikely to recover any time soon, meaning that enforcement is becoming hard to ignore for most lenders, including CMBS deals.

The retail sector and certain parts of the consumer-related sector have been particularly badly hit, according to Downey - with borrowers getting into difficulties regarding downturns in business, their business plans and not having the resources or management structures in place to deal with them. "It is becoming clear that loan enforcement is more difficult and expensive than had been anticipated in some jurisdictions," he says. "The two- to three-year tail used on many deals between bond and loan maturities doesn't appear to be long enough. Additionally, investors - depending on their position in the capital stack and the time they made their investment - will have diverging views as to the desirability of quick enforcement."

Downey adds: "Consequently, we've seen an up-tick in CMBS restructurings. The aim of servicers in these situations is to increase value for bondholders. Potentially this could involve radical plans, such as undertaking debt-for-equity swaps at the bottom of the capital structure." These swaps involve cancelling some of the junior debt and replacing it with an equity position, which typically enables the senior tranches to be refinanced more efficiently and helps preserve their ratings in the interim.

However, many triple-A investors - hedge funds that have bought paper at a discount in the secondary market or the initial investors at close, who would like to reinvest at current spreads - would prefer early repayment. The resulting tension between senior and junior bondholders in some deals adds to the complexity of the situation, where inevitably some transactions will see quick sales and others will be restructured.

Downey says that European CRE CDOs have also been impacted by falling property values, as in some cases B-notes are now worthless. Although some transactions can swap these positions for equity, most deals would risk breaching their IC/OC tests by doing this.

In addition, all of these deals are now experiencing asset valuation problems in the current market. Consequently, many investors are thought to be holding the assets at face value rather than recognising price changes at present value.

CS

Investors

Looking ahead to the 19th century to capitalise on an historic market opportunity

Mark Cernicky, product development manager at Aviva Investors North America, says the current credit crisis has created an historic opportunity for an old style investment banking business model to earn sustainable returns by lending to disenfranchised companies

As we enter 2009, let's look ahead and stop asking who or what should take the blame for the current economic mess: sub-prime, credit derivatives, "quants" or even Alan Greenspan's low interest rate policy which inflated housing prices.

As a result of the application of leverage to poor credit underwriting, investors today have an historic opportunity to earn attractive and sustainable risk-adjusted returns through active credit underwriting. Moreover, despite the pain of 2008, there are plenty of investors that are a little excited for 2009. They know that if they can capitalise on the opportunities created from this crisis, they could become the next George Soros or Julian Robertson.

But the point is not who will do that; rather, it's the opportunity itself. Low leverage, long-only strategies focused on lending to disenfranchised borrowers represent an historic opportunity for the right asset manager.

Moving beyond the tactical to long-only strategies
We should look beyond the tactical to the strategic: from arbitrage-driven strategies to long-only strategies. This is not to suggest that there are not opportunities in "absolute return" or "alpha" strategies.

For example, long-short credit strategies and tactical asset allocation strategies can take advantage of current dislocations in the market and may represent an attractive way to add return with little portfolio ballast. However, the opportunity in long-only strategies is much more historic because only certain managers will be able to capitalise on the opportunity and therefore earn sustainable long-term returns.

In addition, these technical pressures have not been discriminating. Well-run companies trade like bad companies; secured assets trade at lower prices than unsecured assets.

Realised volatility is extreme; however, unidirectional volatility can be challenging, even for long-short strategies. In addition, de-leveraging continues.

As a result, when market technicals dominate credit fundamentals, the catalyst for arbitrage, mean-reversion may not be present. This makes it harder to harvest gains from typical arbitrage strategies or even basis trades.

Most arbitrage strategies also require leverage to hit their return targets, making them susceptible to margin close-outs. Long, directional strategies that don't use leverage should be able to withstand the excessive market technicals.

Furthermore, strategies that do not require tactical trading opportunities to generate returns are more likely to be sustainable. A long-only strategy focused on providing loans to well-run companies without access to capital markets - disenfranchised companies - represents an historic investment opportunity.

Declining conventional financing alternatives for good borrowers
Commercial banks will not be in a position to lend as they did in the past. Capital is too precious, despite government infusions. Banks de-leverage and continue to lose capital as companies draw down on their reserves.

Bank consolidation also will continue to distract from lending opportunities. As a result, banks are likely to keep their capital for their biggest clients and for lending to home buyers. They are less likely, for example, to make it available to the US$400m industrial company that makes parts for fast-food restaurant fry machines under a long-term contract.

This creates a class of disenfranchised borrowers that is likely to persist for some time. Because of the secular decline in the conventional financing alternatives for good borrowers, a strategy focused on lending to disenfranchised companies has an opportunity to earn attractive and sustainable risk-adjusted returns for its investors.

This sustainability is burnished by several barriers to entry. Capitalising on the opportunity requires a talent that not everyone has: active credit underwriting, which has become an endangered species.

1. Active credit underwriting is required
Remember bank underwriters? Not the passive credit underwriting in which you pick up a 10-K, read some rating agency research reports and then write an opinion.

Active underwriting requires real due diligence. It requires analysts who conduct plant tours, meet with management, speak with customers and suppliers and understand how to write covenants - basically, what bank underwriters used to do.

The lack of active credit underwriting and investors' reliance on the passive underwriting of others had much to do with the credit crisis. Many investors thought they could rely on someone else to do the credit work, whether this was through rating agencies, investment banks or even hedge funds.

As long as liquidity was ample and the economy rolled along, passive credit underwriting appeared to work. Unfortunately, liquidity dried up and the economy contracted, exposing the danger of leveraging poor credit underwriting. Going forward, navigating the crisis requires active credit underwriting.

2. Partner with an asset manager with permanency
Because loans made to the disenfranchised companies are illiquid, an asset manager will have to obtain permanent or committed financing in order to capitalise on this lending opportunity. To provide permanent financing for these attractive risk-adjusted returns, investors will be looking for an asset manager with certain characteristics: some permanency, strong capital, a long-term track record of underwriting credit and a deep organisation with separate risk and operations groups.

In addition, the asset manager will need to have access to a pipeline of prospective borrowers and these borrowers will be looking for a partner - someone with permanency, similar to investors.

3. Lending today creates business tomorrow
There is a powerful second-order effect from lending to the disenfranchised borrower. It can stimulate sustained long-term fees, which translate into long-term performance for investors. The concept is that lending today creates business tomorrow.

If you help a client in times of distress, you become that client's partner. As a partner, you are more likely to be asked to help them in the good times as well; for example, in obtaining future merger activity or other advisory business. As a result, investors have an ability to extract a long-term annuity from the borrowers that they partner with, much as the old investment banks did.

Those investment banks and merchant banks did actual underwriting for their investors. For instance, prior to selling the debt of a US railroad to European investors, the house of Morgan would meet with the railroad's customers and management to make sure that investors could reasonably expect to get their money back. Those relationships, which were cultivated by J.P. Morgan through the bank's lending, often led to additional work from the US railroads and provided the footings for one of the most powerful US investment banks at the turn of the 20th century.

Move over George Soros, here comes J.P. Morgan
Long-only lending represents an historic opportunity to earn sustainable returns without leverage. The secular decline in bank lending creates a long-term opportunity to lend to disenfranchised borrowers. However, it requires the right asset manager to capitalise on the opportunity.

That asset manager will need to have the right combination of characteristics: permanency, active credit underwriting and a willingness to be a partner - not a loan shark. That's very similar to the way in which the old investment banks operated. Perhaps the next George Soros will look like J.P. Morgan.

Disclaimer
Opinions expressed herein were drafted as of the date of this article, and are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Any statement concerning financial market trends is based on current or past market conditions which can fluctuate over time. Information contained herein has been obtained from sources believed to be reliable, but the accuracy of such information is not guaranteed by the author or Aviva Investors^SM North America, Inc.

Investors

Moving down the complexity ladder

Ron D'Vari, ceo of NewOak Capital, answers SCI's questions

Ron D'Vari

Q: When did NewOak Capital become involved in structured credit?
A: NewOak Capital was founded by James Frischling, previously head of structured credit products at Fortis Securities, and myself (I was previously head of structured finance at BlackRock) in 2008. The firm was created to provide independent and unbiased services in response to the unprecedented challenges in the financial markets. We are experts in residential and commercial mortgage loans, corporate credit and the universe of structured products and related derivatives (ABS, RMBS, CMBS, CDOs, CLOs, CSOs, ARS and CDS).

Q: What has been the most significant development in the credit market in recent years?
A: Over the last six to 12 months it has become clear that the traditional model of managing assets is no longer applicable because the entire debt market has changed and the traditional moral contract between borrower and lender is broken. Instead of an asset manager raising money and then deploying it at their discretion, the new model involves identifying an asset and then finding an interested/appropriate investor. Asset transfers were to some extent driven by accounting reasons or upon the condition of the seller, but now it is necessary to provide what we call a 'certificate of authentication', i.e. a full see-through look at underlying collateral and panorama of different outcomes throughout over time.

Q: How has this affected your business?
A: We saw an opportunity to look at the market in a fresh way: investment management now essentially integrates the investment advisory and trader roles, and requires the creation of a balance of risk and reward for both the buyer and seller. With many large organisations under pressure themselves, there is a chance for smaller, flexible players to maximise value in the structured credit space. Members of our team are highly experienced and have been through two or three credit cycles already, meaning that they have the necessary comprehension of what may be ahead.

Q: What are your key areas of focus today?
A: We have been covering the full range of structured products, but the recent shift has been to CLOs and commercial real estate distressed debt. In commercial real estate, the most hard-hit sector has been what we call 'busted' developments. We deal typically with large portfolios, but lately it has been biased towards complex real estate developments, covering a number of different states, where the developers are no longer in a position to complete the projects. The complexity lies in valuing the asset where the lender is no longer around, the cooperative relationship with the borrower has disappeared and the developer has negative economic interest to finish the project through sales.

We analyse every loan on its own by moving back down the complexity ladder. Historically, investors weren't prepared to do such granular analysis and so securitisation was created to bring liquidity to the underlying assets - but this means that the system is completely unprepared for the kind of analysis that is necessary today.

By re-underwriting each loan, creating a value for the asset becomes a comprehensible, measurable process. But in order to re-underwrite the loan, we need to know what leases there are and where, as well as understand the balance sheet/business plan of the borrower and where the money is coming from.

Over the last 20 years the emphasis has been on building things that are less tangible, so now it is a question of unravelling the value chain. Our model focuses on the raw material and includes several steps before an asset is ready to sell on.

Using a medical analogy, first we identify what the disease is, then we operate using refinancing or loan modification and a portion may have to go to the morgue while another may have to remain in hospital to rest (i.e. it's put into special servicing). Sometimes we'll re-underwrite a loan to make it eligible for an FHA guarantee. An estimated 70%-80% of modifications have to be re-modified, but we made a decision to get the modification right the first time - if you have to go through the process again, the borrower and the market are likely to be in even worse shape.

At any given time, we may be dealing with as many as thousands of assets split into different types. These assets could be related to FDIC auctions or other investors' valuation/de-risking exercises.

We have good relationships in the market and are known to be forward-looking, so investors typically come to us for solutions or new ways of sourcing or hedging their existing risks. We usually explain our processes to them first and then contact them if we think a particular asset or portfolio may fit their strategy and risk capacity.

For example, a number of our customers are private equity firms, which recognise that it is more efficient to diversify via our organisation than creating the infrastructure themselves - particularly if it isn't an asset class they're intending to remain in for the long term. They will look at our assumptions and then judge whether we're adding value.

What is your strategy going forward?
We continue to innovate and strive to stay a few steps ahead of the market and real events. Our strategy focuses on building the-best-in-class infrastructure and expertise base to manage high-touch assets, such as distressed residential mortgages, commercial real estate and leverage loans in large scale in raw (loan) as well as securitised forms, but at the same time not sacrifice any granularity.

Some of the toughest assets to manage will be residential and commercial real estate developments, but that is where the most ability to add value and highest returns are. We have made significant hires in these areas and will continue to do so selectively.

The ability to approach these assets fresh, without any of the old baggage or legacy systems, affords NewOak Capital tremendous advantage over time. We are actively looking at expanding our special servicing capabilities and focus on added-value management.

What major developments do you need/expect from the market in the future?
As bad as the conditions may look currently, we believe we have not seen real wide-spread capitulation in the market as yet. As long as financial institutions are incentivised to keep the bad assets on their balance sheets and finance them cheaply with government-provided liquidity, the assets will not find their way in the portfolios that can tolerate the risk. In turn, the appetite for fresh lending will continue to shrink and delevering will continue.

About NewOak Capital
NewOak Capital is an independent, employee-owned firm founded to provide the highest quality advisory, asset management and capital markets services to a broad range of investors, institutions and their professional advisors globally.

The firm is staffed by a team of seasoned professionals with a broad array of experience across asset classes. Its ultimate mission is to help its clients understand, plan and achieve their financial objectives.

Bank winds down SF unit

The latest company and people moves

Bank winds down SF unit
Ganesh Rajendra has left Deutsche Bank, where he was head of European ABS research. Rajendra's departure is understood to be one of a number of departures in the structured finance department made over the past couple of weeks, as the bank reportedly winds down its structured finance and structured credit operations. A spokesperson was unable to comment on any of the reports.

Rajendra joins a growing list of research heads that have left their respective banks over the past few months. Among them are Marcus Hermann of HSBC and Birgit Specht of Citi.

RBS is also understood to have made a number of personnel cuts across the bank last week, with a high concentration in the structured credit department, according to head-hunters.

Navigant adds one
Navigant Consulting, a firm that provides dispute, investigative, operational, risk management and financial advisory solutions, has appointed Robert Picard as senior advisor. He will provide services for the firm's financial institutions restructuring solutions team, part of Navigant Capital Advisors (NCA), the corporate finance business unit of Navigant Consulting. The team provides a full suite of services to stressed and distressed financial institutions.

Picard most recently served as cio at Optima Fund Management, overseeing US$6.5bn in hedge fund of fund investments. Prior to joining Optima, Picard was an md at The Carlyle Group, where he built and managed the process and portfolio of an innovative hedge fund business that provided a platform for institutions investing in alternative investments.

AIMA rejigs management team
The Alternative Investment Management Association (AIMA) has appointed Todd Groome - currently of the International Monetary Fund - as its non-executive chairman, at it restructures its executive team.

Groome has been responsible for multilateral surveillance activities and review of capital markets issues, focusing on structural issues, with a leading role on financial stability analysis and considerations for the IMF, including production of the Fund's Global Financial Stability Report. Prior to this role, he has held senior positions at institutions in London, New York and Washington, DC, including Deutsche Bank, Merrill Lynch and law firm Hogan & Hartson.

Additionally, Andrew Baker has been appointed ceo of AIMA, while Florence Lombard has been named executive director to take on a new, international advocacy role for the industry.

In light of the market crisis and the impact this has had on the hedge fund industry, AIMA announced in October its intention to focus its resources more heavily on engaging with policymakers and regulatory authorities. This redefining of roles enables Lombard to focus her attention more fully on the pressing needs of policymakers around the world, and to actively promote the industry's position and concerns with governments and policy advisers internationally. She will continue with her responsibility for Asia-Pacific activities.

Baker will take over the running of the Association, will continue to hold responsibility for the Americas and EMEA activities of AIMA, and will complement Lombard's policy activities - particularly in the UK. He also retains his ownership of all of the Association's ongoing sound practices initiatives.

Credit fund wound down
ING New Zealand is winding down its US$27m Enhanced Yield Fund and US$8m Credit Opportunities Fund. "These two funds were established in a fundamentally different market environment from the one the world now finds itself in. The financial world has changed dramatically for all of us," comments Helen Troup, ING New Zealand ceo.

No further withdrawals or applications will be processed for either fund. The funds are to be closed and wound down.

"Both ING and the trustee recognise the significance of this decision, which has only been reached after careful consideration of the situation," Troup says. "Severe deterioration of market conditions during October and November has necessitated taking action on these two funds now to protect the interests of investors."

Permacap November results in
Carador's NAV per share decreased by €0.0768 or 12.89% in November. The month's calculations include an estimated €313,627.98 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0063 per Share.

The company's pricing committee considered it prudent to bring forward the quarterly recalculation of the base IRR used to price the portfolio to take into account the market volatility experienced in October and November. This base IRR increased by 577bp to 36.69%. Excluding the effect of the change in the base IRR, it is estimated that the NAV would have decreased by €0.0099 per share.

There were five loan defaults in the leveraged loan market in November. Carador had exposure to only one of these names through three portfolios, with an average exposure per name of 0.31%. The company's cumulative underlying portfolio default rate since inception (April 2006) is 1.04% or 0.39% annualised.

As at the close of business on 30 November 2008, the unaudited net asset value per share was €0.5186.

Monoline hires general counsel
Financial guarantor ACA has hired Steven Berkowitz as its new general counsel. His appointment follows the Maryland Insurance Administration's approval of a restructuring plan for ACA, which took effect on 8 August. In September, an entirely new board of directors and ceo were announced as part of the company's restructuring (see SCI issue 103), and Berkowitz is the latest addition to this transitional management team.

Berkowitz spent the past 16 years with FSA, where he most recently was an md in the asset finance group. Prior to this position at FSA, he was md of the municipal structured finance group and worked in the legal department as md and associate general counsel.

Fortis/BNPP tie-up postponed
Fortis has been prevented from selling Fortis Insurance Belgium to BNP Paribas, following a court ruling prompted by Fortis shareholders. As a result of the court ruling, the envisaged structured credit portfolio entity - in which Fortis would hold a 66% interest - will not be accounted for by Fortis Holding. This entity forms part of the agreement with BNP Paribas and the Belgian State, and will therefore not be included for as long as that agreement is suspended.

AC

Auto manufacturers' fate discussed

A round up of this week's structured credit news

Auto manufacturers' fate discussed
The US government will likely provide immediate stop-gap financing to bridge the major American auto companies until a more complete agreement can be reached early in 2009, says Moody's in a new report that outlines the three mostly likely bailout and bankruptcy scenarios for government help to Ford, GM and Chrysler.

"We think it's most likely that a prepackaged bankruptcy filing, coupled with government financial assistance will be needed to restructure the Big Three," says Moody's svp Bruce Clark, a co-author of the report. "The government will also probably offer support by providing or guaranteeing debtor-in-possession or DIP financing, and bondholder losses would probably be less than 75% in this scenario."

In the wake of the domestic auto manufacturing companies' request for urgent financial assistance from the federal government, the Moody's report describes three bailout and bankruptcy scenarios for Detroit, assesses the probabilities of these scenarios and examines the extent of likely losses in each of the scenarios for auto manufacturer debt holders. It then assesses the broader implications of the three scenarios, across the larger economy generally and specifically on 10 important financial and industrial sectors.

These include auto-part manufacturers, captive finance companies, car rental companies, banks, auto dealers, steel, chemicals, rental car fleet securitisations, state and local governments, dealer floorplan securitisations, auto loan/lease securitisations and rental car fleet securitisations. "A prepackaged bankruptcy might be the best approach to current problems, but achieving timely agreement from a broad range of creditors would be highly difficult, especially given the critical funding status of GM and Chrysler," adds Clark.

While Moody's gives a prepackaged bankruptcy filing, coupled with government financial assistance a 70% likelihood of coming to pass, they assign a 25% probability of a government bailout without a near-term automaker bankruptcy. "Under this less-likely scenario, a comprehensive bailout package is agreed to that enables the automakers to restructure without any bankruptcy filings during 2009. The degree of economic disruption and direct financial loss for investors would be contained, at least in the short term," continues Clark. "Bondholder losses would be the least in this scenario, although there is a risk that such a reorganisation would be inadequate, and that at least one automaker might file for bankruptcy beyond 2009."

Given only a 5% likelihood, Moody's also considers the 'freefall bankruptcy' scenario without a prepackage plan and without government involvement. This would involve the most significant disruption to the economy, including potential bankruptcies in associated industries such as auto parts suppliers and auto dealers.

"The negative consumer sentiment and erosion of franchise value would make the reorganisation process more complex for the automakers and a Chapter 7 liquidation of at least one of the automakers possible," notes Clark. "Auto bondholder losses could be in the 75%-100% range in this scenario."

CLO rating assumptions reviewed
S&P is conducting a review of all assumptions and methodologies used to assign CLO ratings, including those involving asset recoveries, default rates and correlation. Any resulting changes to the agency's assumptions and methodologies may raise credit enhancement levels for all rating categories, potentially leading to changes in some outstanding CLOs.

S&P believes that any classes it downgrades due to deterioration of the CLO collateral will primarily be the more subordinate notes. The effect of these changes on the ratings of any particular existing CLO will depend on the agency's analysis of the credit quality of its portfolio of underlying loans, its structural features and its investment guidelines.

Corporate speculative grade default rates have already more than quadrupled in the past year, rising to 4.1% according to S&P LCD, from 0.97% in December 2007. These rates are expected to reach somewhere between 8% and 10% by the end of 2009, and a three-year cumulative level of almost 24%.

If these estimates are realised, S&P global fixed income research suggests that 353 speculative-grade rated non-financial firms could default between 2008 and 2010, with potentially more than 200 of these defaults occurring in the second half of 2009 and in 2010. Consumer-sensitive sectors - such as consumer products, media and entertainment, and retail and restaurants - are expected to be among the worst hit, in line with what happened in 1990-1992.

As a reflection of this, the level of leveraged loans currently rated triple-C plus and lower increased to 8.2% in November, up from 4.4% in October (see last week's issue). At the same time, the pace of asset liquidations by financial institutions and hedge funds continues to be fuelled by the increasing strain on capital requirements and rising hedge fund redemptions.

Unsurprisingly, market prices of speculative-grade securities, including loans, continue to trade at prices significantly below par. According to S&P's LCD Composite Index, in December, loan bids hit another record low of 64.83.

Similarly in Europe, credit conditions are deteriorating for leveraged companies. There has been a downward rating migration both for S&P's publicly rated credits and its portfolio of credit estimates during 2008.

Triple-C credits grew to 5.2% of the credit estimate portfolio in mid-November from 1.6% at the end of 2007. For S&P's publicly rated companies in EMEA, credits within triple-C categories now comprise 8.8% of its publicly rated speculative-grade industrial ratings, compared with 3.3% at year-end 2007.

With the corporate credit picture worsening, existing CLOs backed by speculative-grade loans have come under pressure. These market conditions prompted S&P on 5 December to put on review for downgrade 197 CLO tranches from 127 vehicles totalling some US$3.89bn, and may lead to additional credit watch placements in coming weeks.

According to S&P, the CLO sector as a whole appears to have considerable exposure to 250 corporate issuers. Future downgrades of the assets backing CLO securities would negatively impact the liquidity and valuations of those underlying assets as well as that of CLO securities, notwithstanding the buy-and-hold strategy of cashflow CDO structures. "As the ratings of the underlying assets come under pressure, we expect the number and severity of CLO rating downgrades to increase," say S&P.

Some of the key risks affecting CLOs in S&P's analysis are:

• Collateral performance, such as defaults, rating transition and recovery rates;
• Structural features, including coverage tests and event of default triggers; and
• Market risk/asset valuations.

Positive trend for US home prices?
The year-on-year HPA decline, based on LoanPerformance housing index data, was -17.34% in October compared to -18.55% in September and -19.15% in August. Although home prices are still experiencing steep declines, this latest data is a clear sign of easing, according to structured finance analysts at JPMorgan.

"Accounting for seasonality and our projected revisions, one-month annualised HPA was down -16.67% in August 2008, September was down -15.59% and October -12.27%," they note. "It is clear that, despite downward revisions, the trend is upward and the bottom in monthly declines has been reached."

JPMorgan expects the one-month HPA to be in the negative single-digit territory in the spring and flat by the end of 2009. "We continue to project a -35% peak-to-trough for housing, which is now less conservative than RPX-implied figures. We feel smaller monthly declines will persist through 2009 into early 2010 and eventually reach zero by early 2010," the analysts conclude.

Moody's updates SF CDO modelling parameters ...
Moody's has revised and updated the key modelling parameter assumptions it uses to rate and monitor ratings of structured finance CDOs, affecting asset correlation, default probability and recovery rate. The changes are in response to weak performance of certain structured finance asset classes over the past two years, the limited near-term opportunities for consumers and corporates to refinance debt, and the increasingly negative credit outlook for the global economy.

As a result of the revised assumptions, Moody's anticipates that a large number of existing SF CDO ratings will be downgraded by approximately three notches and will remain on review for possible further downgrade. Ratings of a small number of tranches may be downgraded by more or less than three notches, or not at all, depending on numerous factors - including their vintage, current rating, portfolio composition and credit enhancement. Moody's expects to complete these rating actions before year-end.

For rating SF CDOs, Moody's currently uses a Gaussian copula model, incorporated in its public CDO rating model CDOROMv2.4 to generate a portfolio loss distribution. The existing parameters within this framework have been revised, resulting in asset correlations that are approximately two to three times higher than their current values.

In light of the systematic seizure in the housing market and the credit markets in general, Moody's has made the following primary changes in asset correlations:

• Increasing the base global and meta sector asset correlations
• Creating a single RMBS category that includes prime, Alt-A and sub-prime RMBS securities, which all have experienced substantial credit performance deterioration
• Reducing diversification credit for SF CDOs that have a high concentration in one type of structured finance asset
• Combining the current commercial real estate and corporate meta sectors into a single meta sector and introducing a real estate add-on factor to increase the cross-sector correlation between real estate-related assets
• Increasing the penalty for geographic concentration
• Reducing the vintage diversification benefits and allocating vintage concentration penalty to all sector and geography levels
• Assuming higher asset correlation for highly-rated structured finance assets than for lowly-rated assets.

Moody's will also now apply resecuritisation stress factors to default probability assumptions for structured finance asset collateral underlying both new and existing SF CDO transactions. The resecuritisation stress addresses the leveraged rating impact on SF CDOs of changes in their underlying collateral performance and had previously been applied only to new ratings.

... and downgrades affected tranches ...
Moody's has downgraded its ratings of 164 notes issued by certain structured finance CDOs, each of which was originated in 2007 or 2008, after applying its revised modelling parameter assumptions for SF CDOs. The agency notes that most of the lowered ratings remain on review for possible downgrade due to the continuing weakness in the performance of and outlook for structured finance securities that back SF CDOs. It anticipates that in the coming days it will announce additional rating actions applicable to SF CDOs of earlier vintages as the revised assumptions are applied to those transactions.

... while Fitch also finalises SF CDO approach
Fitch has published its updated approach for rating structured finance CDOs, following an eight-week consultation period. The criteria contain updated default probabilities (based on rating and term of asset), increased correlation assumptions and recovery rate assumptions that are based on tranche thickness. The correlation framework has been calibrated so that CDO notes rated in the high investment-grade categories would be protected against estimated peak default potential for portfolios of SF assets concentrated in terms of geography, sector and vintage.

Much of the feedback received during the consultation period focused on the correlation calibration. Some market participants thought that treating RMBS as a single sector did not give enough benefit to the different risk drivers of the conforming and non-conforming sectors.

"While we agree that differences in RMBS risk drivers may lead to distinction in observed default correlation during mild or even moderate stress scenarios, we continue to believe that in high stress scenarios, correlation will prove to be high," says John Olert, md and head of global structured credit at Fitch in New York.

Another common element of feedback related to the application of US-based performance statistics to non-US portfolios. The approach focuses on the potential for a peak default rate for a portfolio of concentrated assets. It does not represent an expected portfolio default rate, but rather recognises that there is a higher potential for portfolio default rate variability in concentrated portfolios.

"The data we used to influence our thinking were skewed toward poorly performing US SF sectors, but we believe that any concentrated portfolio can pose the same risk," adds Ken Gill, md at Fitch.

The more recent clarifications focused on treatment of real estate investment trust (REIT) and commercial real estate loan (CREL) assets. The correlation assumptions for REIT assets recognise a higher intra-industry correlation compared to other corporate industries, but still provide a small amount of diversification credit when adding REIT debt to a portfolio of CMBS. The CREL correlation assumptions recognise the potential for high correlation in high stress scenarios, while still recognising that idiosyncratic factors such as property type, quality and location, may reduce default correlation between CREL and CMBS.

The criteria will be applied to review the current ratings assigned to all SF CDOs and rating actions are expected beginning in January. For SF CDOs already exposed to distressed US RMBS securities, the application of the revised criteria is not expected to result in any meaningful rating changes.

For European SF CDOs with no or limited exposure to US RMBS securities, the application of the new criteria is expected to produce some affirmations of triple-A ratings; however, many triple-A rated securities are expected to be downgraded an average of three categories to the triple-B level. For US CRE CDOs, some senior triple-A rated tranches may also be affirmed, but many are expected to be downgraded by three or four categories (to triple-B or double-B).

LCDX credit event called on Tribune
Dealers have voted to participate in a credit event auction to facilitate the settlement of LCDS trades referencing Tribune Co, a constituent of the Markit LCDX index. The auction terms, including the auction date, will be determined according to LCDS auction rules published by ISDA. A separate credit event auction will be held to facilitate the settlement of CDS trades referencing the company, which is also a constituent of the Markit CDX index.

Based on November data of loan issuer concentrations in their broad CLO collateral universe, JPMorgan structured credit analysts note that Tribune is among the top-10 loan issuers for a total exposure of about US$1.3bn across transactions. In fact, nearly 300 US CLOs are exposed to the name, based on the latest data from Intex.

The average exposure is 0.8% and ranges from 0.07% to 6.2%. These numbers suggest significant variation in cashflows for CLOs in upcoming reporting periods. However, the strategists warn that even CLOs at the very low end of the exposure distribution could lose as much as a point of overcollateralisation, given the credit's low implicit recovery at the current market price (around US$25 for term loan Bs).

Ratings guidance released for asset managers
EFAMA, the ESF and the IMA have jointly published 'Asset Management Industry Guidelines to Address Over-Reliance upon Ratings', providing guidance for asset managers on the responsible use of ratings for securitisation, structured finance and structured credit products. Four main guidelines are included in the document:

• When investing in structured credit products asset managers must have regard to their obligation to act professionally and in the best interests of their clients.
• Asset managers should understand the limitations to any credit ratings and to address the risks arising.
• In the best interests of their clients, where appropriate, asset managers should challenge mandates which appear ill-designed.
• Asset managers should periodically assess the adequacy and effectiveness of their arrangements for addressing the above guidelines.

The Guidelines show the industry's strong commitment to apply the lessons learned from the recent financial turmoil, the three Associations say. They have been produced as a response to the call of the Financial Stability Forum (FSF) on investors to address their over-reliance on ratings and to review their standards of due diligence and credit analysis when investing in structured credit products.

Primus downgraded ...
S&P has lowered its ratings on Primus Financial Products from double-A plus to double-A minus, where they remain on credit watch with negative implications. The rating action reflects the fact that the CDPC's credit derivative portfolio has weakened further and S&P's view regarding the uncertainty of the outcome of the settlement of Primus' swaps with Lehman Brothers Special Financing Inc.

Primus has absorbed losses due to credit event settlements on several of the reference entities in its credit derivative portfolio, including Freddie Mac, Fannie Mae, Lehman Brothers Holdings Inc, Washington Mutual Inc and Kaupthing Bank. Based on information S&P has received, the agency believes that as of 9 December, 1.43% of Primus' single name portfolio consisted of reference obligors that have ratings below single-B (based on the swaps' notional amount), excluding the CDS on the above-mentioned defaulted reference obligors and those with Lehman Brothers Special Financing.

"It is our understanding that Primus' credit derivative swaps with Lehman Brothers Special Financing Inc are all on single name entities, have a US$1.37bn notional amount and an approximately US$65m mark-to-market. We are lowering our ratings on Primus because our analytic approach to rating CDPCs incorporates the need for adequate capital resources to address potential termination payments," the agency notes.

S&P is leaving the ratings on credit watch negative because it anticipates that, over the near term, Primus may experience further losses as a result of credit events from the reference obligors that have ratings below single-B. The agency expects to resolve Primus' credit watch placement once losses from any new credit events on reference obligors rated below single-B have been realised or the credit quality of Primus' portfolio improves.

Based on the current information that S&P has received from Primus management, the agency expects to keep its issuer credit rating on Primus at the current level. However, new credit events or further credit deterioration in the CDPC's credit derivative portfolio could lead the agency to lower its credit ratings by an additional one to three notches.

... while provisional CDPC rating withdrawn
Moody's has withdrawn its provisional counterparty rating of (P)Aaa on Harbor Road Financial Products, the CDPC managed by Tricadia Holdings subsidiary Tricadia CDPC Management. Harbor Road has requested the withdrawal of its provisional counterparty rating for business reasons, according to the rating agency.

Disclosure of VIE interests to improve ...
The Financial Accounting Standards Board (FASB) has issued FASB Staff Position (FSP) FAS 140-4 and FIN 46(R)-8, 'Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities'. The document sets forth increased disclosure requirements for public companies and is effective for reporting periods (interim and annual) that end after 15 December.

The purpose of the FSP is to promptly improve disclosures by public entities and enterprises until the pending amendments to FASB Statement No. 140, 'Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities', and FASB Interpretation No. 46 (revised December 2003), 'Consolidation of Variable Interest Entities', are finalised and approved by the Board. The FSP amends Statement 140 to require public entities to provide additional disclosures about transferors' continuing involvements with transferred financial assets.

It also amends Interpretation 46(R) to require public enterprises, including sponsors that have a variable interest in a variable interest entity, to provide additional disclosures about their involvement with variable interest entities. Additionally, the FSP requires disclosures by a public enterprise that is (a) a sponsor of a qualifying SPE that holds a variable interest in the qualifying SPE but was not the transferor of financial assets to the qualifying SPE and (b) a servicer of a qualifying SPE that holds a significant variable interest in the qualifying SPE but was not the transferor of financial assets to the qualifying SPE.

... while business combinations accounting reviewed
FASB has also issued a proposed FASB Staff Position (FSP) FAS 141(R)-a, 'Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies'. The proposed FSP would amend FASB Statement No. 141 (revised 2007), 'Business Combinations', related to the accounting for assets and liabilities arising from contingencies in a business combination.

The proposed FSP is intended to improve financial reporting by addressing concerns from preparers, auditors and members of the legal profession about the application of Statement 141(R) related to the initial and subsequent recognition and measurement, and disclosure of assets and liabilities arising from contingencies in a business combination. This would require that an asset or a liability arising from a contingency in a business combination be recognised at fair value if fair value can be reasonably determined and would provide guidance on how to make that determination.

If the fair value of an asset or liability cannot be reasonably determined, the FSP would require that an asset or liability be recognised at the amount that would be recognised in accordance with FASB Statement No. 5, 'Accounting for Contingencies', and FASB Interpretation No. 14, 'Reasonable Estimation of the Amount of a Loss', for liabilities and an amount using similar criteria for assets. The proposed FSP also would amend the subsequent measurement and accounting guidance and the disclosure requirements for assets and liabilities arising from contingencies in a business combination.

Negative outlook for EM CDOs
When Moody's published its '2008 Mid-Year Outlooks for Global CDOs/Derivatives' in September 2008, its central macroeconomic scenario was assuming strong growth in emerging countries. The vast majority of sovereign credits were then showing a stable outlook, with less than 2% of the issuers placed under review for possible downgrade or associated with a negative outlook. Consequently, Moody's outlook on emerging markets CDOs indicated a predominantly stable collateral performance and limited CDO rating implications, barring any excessive concentration in riskier credits.

Since then, the financial crisis has started to affect the prospects for emerging market economies and Moody's has published updated macroeconomic scenarios where EM growth prospects have been revised downwards. The agency's central scenario for 2009-2010 of 'global healing' now generally expects emerging economies to grow below potential.

The proportion of sovereign issuers on review for downgrade or with a negative outlook has increased to above 6%, from less than 2% three months ago. Beyond its impact on the performance of sovereign issuers, the global financial crisis has increased the pressure on internal banking systems, which will have in turn further negative impact on the performance of emerging markets corporates. As a result, CDO collateral pools with significant concentration of emerging markets, be it through corporate or sovereign issuers, are expected to experience credit quality deterioration.

Based on these considerations, Moody's has revised its EM CDOs collateral performance outlook to negative from stable, and expects rating implications to be negative on EM CDOs tranches. The extent of the rating changes on such tranches will depend on each individual portfolio composition, the evolution of the global macroeconomic environment and on its impact on EM sovereign and corporate issuers.

From a shorter-term perspective, Moody's global sovereign group published a special comment entitled 'Rating Sovereigns During a Global "Sudden Stop" in International Funding', where it highlighted that the current funding dearth experienced by EM countries is of a temporary nature, with most countries being able to endure it due to adequate reserves, access to non-market funding and/or sufficient integration in the world economy. However, the group identified a list of 'High Vigilance Countries'; i.e. countries that appear vulnerable to the current crisis and are more likely to face rating pressures.

Among these are Hungary, Croatia, Romania, Bulgaria, Korea, Kazakhstan, Turkey, Ukraine, South Africa, Pakistan and the Baltic countries. The group has already started taking isolated rating actions, for example, on Ecuador, Pakistan, Jamaica, Hungary, Estonia, Latvia and Lithuania.

Moody's currently rates 29 CDOs exposed mainly to EM risk, 17 of which have significant exposure (i.e. more than 5% of the pool) to these 'High Vigilance' countries. However, except for a couple of transactions that have a large exposure to these countries (i.e. typically over 20% of the pool), the agency does not expect the rating actions that may be taken in the coming weeks with respect to sovereign issuers to have a significant rating impact on the ratings of these CDO tranches.

GFI reports on annual CDS activity ...
The CDS market has this year seen active trading in Lehman Brothers, Merrill Lynch, Washington Mutual, CIT Group and Countrywide Home Loans - making banking and financial services the most active categories of 2008, according to GFI. The auto manufacturing sector rounded out the most active sectors in the US.

In Europe the fixed-line telecom sector dominated (as it has for the previous three years), boosted by four of the five most active single names - Telecom Italia, Deutsche Telecom, France Telecom and Telefonica. The banking sector and food retail and wholesale sectors rounded out the most active list for the region.

Finally, the financial services sector was also the most active in Asia in 2008, with Japanese companies Aiful and Takefuji leading the most traded single names. Banking services was the second most active sector in the region, led by Kazakhstani banks JSC Kazkommertsbank, Bank TuranAlem and Japanese bank ACOM.

Meanwhile, Turkey, Russia and Brazil were the three most actively traded sovereigns for 2008, with Ukraine and Kazakhstan rounding out the top five.

... while CMA examines sovereign debt risk
CMA DataVision has released a paper focusing on the recent fluctuations of international sovereign debt risk, with the intention of identifying trends and drivers of change. The findings show that world sovereign debt risk has risen across the board as the financial crisis has deepened; for example, the collective median of German, French, Italian, Irish and Swedish debt has risen 100 points in the past three months. The correlation of world economies can also be seen from the similar peaks of the curves in sovereign debt groups.

Not only have sovereigns become more actively traded, but they have also become more volatile, according to the report. The sovereigns that have proven the most volatile in the past three months are: Ukraine, Russia, UK/US, Iceland and Ireland. In response to the crisis, sovereigns have turned to nationalisation, assuming partial/complete debt of banks and private companies, thereby further driving trading and volatility.

Countries listed as least likely to default are highly evolved capitalist nations, with stable, democratic systems of government and diversified economies with little chance of regional conflict. Sovereign debt in emerging markets is seen as most risky, with South America, the Middle East and Asia featuring prominently. Risk drivers include political instability, terrorist threats, weak rule of law, high corruption, a heavy dependency on select industries or natural resources, and a poorly developed or immature financial infrastructure.

CRE CDO delinquencies decline
Delinquencies for US commercial real estate loan (CREL) CDOs fell by 33bp to 2.80% for November 2008 from 3.13% in October 2008, representing the first decline since July, according to Fitch.

"The continued lack of available capital is driving maturity defaults of CRE loans," says Fitch senior director Karen Trebach. "However, asset managers are continuing to extend many of these loans, with the extension of two large performing matured balloon loans leading to the net decline in this month's CREL DI."

Asset managers reported 45 new loan extensions this past month compared to 35 in October. Due to the short-term nature of the loans in CREL pools, Fitch anticipates an average of 40 extensions per month to be exercised going forward, or 3.5% by number of loans in the CREL CDO universe.

As Fitch predicted earlier this year, repurchases are on the decline, with none reported this past month. However, asset managers have been exercising their rights to trade credit risk assets out of CDOs at a loss.

In November, an asset manager sold a recently downgraded real estate bank loan out of a CDO at 26% of the par amount. The effect to the transaction's credit enhancement, however, was minimal as the asset manager had also contributed better performing assets, which were purchased at discounts to par.

Whole loans and A-notes comprise 88% of the CREL DI. Nearly 48% of the loans in the CREL DI are collateralised by multifamily properties.

As the economy worsens, Fitch anticipates a rise in delinquencies, with the most risk attributed to loans backed by hotel and retail properties. These property types make up over 25% of the total universe of loans in Fitch-rated CREL CDOs. Currently, hotel properties comprise 18.6% of the loans in the CREL DI, with retail properties comprising 8.3%.

AIG sells RMBS interests
AIG's US life insurance companies have sold their interests in a pool of US$39.3bn face amount of RMBS to Maiden Lane II, a newly-formed vehicle backed by the New York Fed. AIG says that the creation and launch of this financing entity - which was agreed in principle between AIG and FRBNY on 10 November - will eliminate the liquidity issues associated with its US securities lending programme, which will facilitate the insurer's repayment plan.

Under the agreement, FRBNY extended a senior loan to ML II to enable the purchase of the RMBS for an initial price of US$19.8bn. The loan has a six-year term, subject to extension by FRBNY.

It is secured by the US$39.3bn face amount of RMBS and bears interest at 100bp over one-month Libor. The purchase price may be increased as a result of the payment of the deferred contingent purchase price.

The life insurance companies applied the initial consideration from the sale of the RMBS, along with available cash and US$5.1bn provided by AIG to settle outstanding securities lending transactions under the securities lending programme. Included in the terminations were AIG's securities lending transactions with FRBNY under the securities lending agreement announced in October, which totaled approximately US$20.5bn at 12 December.

To the extent there are sufficient net cash proceeds available to ML II from the RMBS after the senior loan from FRBNY is repaid in full, the life insurance companies will be entitled to receive a portion of the deferred contingent purchase price from ML II of up to US$1bn plus interest at 300bp over. After this fixed amount of deferred contingent purchase price has been paid, the companies will be entitled to receive one-sixth of any remaining net proceeds from the RMBS as additional deferred consideration for the sale of the collateral.

SIV exposure successfully reduced
A recent Fitch review of money market funds globally indicates that funds have successfully reduced their exposures to SIVs over the last year. Specifically, of 47 prime funds reviewed, average SIV exposure decreased to 1% of funds' portfolio balances as of November 2008 from 5% of funds' portfolio balances as of November 2007, including no exposure to ABCP or MTNs issued by Sigma. Furthermore, US-domiciled money market funds have eliminated SIV exposure entirely.

The support of institutional sponsors of money market funds has played an important role in reducing SIV exposure, as certain sponsors have provided funding access for funds or otherwise affected the outright purchase of ABCP and MTNs that were no longer eligible money market fund investments.

From a credit quality perspective, all remaining SIV exposure underlying money market funds is rated single-A plus or higher, consistent with Fitch's rating criteria for AAA/V1+ rated money market funds. The degree of downside risk for remaining underlying SIV collateral is further mitigated by the active support of SIV's sponsoring institutions.

ACA upgraded, ratings withdrawn ...
S&P has raised its financial strength, financial enhancement and issuer credit ratings on ACA Financial Guaranty Corp to single-B from triple-C and removed them from credit watch developing. The outlook is developing. At the same time, the agency also withdrew the ratings at the company's request.

The upgrade reflects the positive effects of the restructuring transaction completed in August that settled all outstanding CDO and reinsurance exposures of the company, including the significantly deteriorated ABS CDO transactions, eliminating a requirement to post a significant amount of collateral to the counterparties. The settlement required that ACA make a US$209m cash payment and a distribution of surplus notes. The surplus notes provide the former CDO counterparties and certain other counterparties with what amounts to a 95% economic interest in the company.

As a result of the transaction, the company's US$7bn risk portfolio is comprised almost exclusively of US public finance exposure predominantly of triple-B and double-B credit quality with above-average concentrations in the health care and higher education sectors. Statutory capital of US$174.7m at 30 September was down from US$414.8m as of 31 December 2007, reflecting in part the cost of the settlement.

S&P assesses ACA's capital adequacy as consistent with a speculative-grade rating, based on a margin of safety in the range of 0.5x-0.7x. The margin of safety expresses the relationship of theoretical losses incurred during a severe stress modelling exercise to capital remaining at the end of the modelling period.

The developing outlook reflects the possibilities that the company could run off in an orderly fashion with capital adequacy improving due to low losses and effective expense management, or that capital adequacy could deteriorate through a combination of meaningful losses.

... while Syncora falls foul of listing standards
Syncora Holdings has been notified by NYSE Regulation that, as a result of its common shares no longer meeting the New York Stock Exchange (NYSE) continued listing standards, the NYSE will suspend trading of Syncora's common stock effective from 17 December. Syncora says that it does not intend to appeal the NYSE's decision at this time and, consequently, it is expected that the common stock will be delisted following the NYSE's application to the Securities and Exchange Commission.

In particular, the company has been advised that its shares are out of compliance with two of the NYSE continued listing standards: maintaining an average market capitalisation of not less than US$75m over a consecutive 30 trading-day period and a stockholders' equity of not less than US$75m; and maintaining an average closing price of not less than US$1.00 over a consecutive 30 trading-day period. According to the monoline, the delisting from the NYSE does not represent any change in its current strategic plan, in the negotiations with financial counterparties or in the involvement by the New York State Insurance Department in its operations.

CS

Trading

Trading ideas: Wild West

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Pioneer Natural Resources Co

The World Bank and the US Energy Department issued gloomy reports last week on the oil market. Both forecasted substantial drops in global oil demand over the next few years, erasing any hopes of a revival to the commodity boom.

In answer to the reports, we suggest buying protection on Pioneer Natural Resources. Our credit model recently turned sharply bearish on Pioneer's credit spread and the company's management is not prepared to weather such a long and harsh storm.

In their recent earnings call, management dialled down earnings expectations, as well as expected capital expenditures for 2009, in order to adjust to the current oil market. They believe the company will be able to generate enough cashflow from operations to fund expected expenditures; however, this was based on a forecasted oil price of US$60/Bbl. With crude sitting just above US$40, the company will likely need to draw on remaining loan commitments under an already strained liquidity position.

Pioneers total debt-to-market capitalisation has shot through the roof in the past few months in response to the drastic drop on oil prices, leaving it with little room to raise capital in either the equity or debt capital markets. Not an enviable position.

Fundamentals
Managing cashflow in the current market is a difficult job for energy company cfos, given the wild swings in commodity prices. In recent quarters, Pioneer's cashflow from operations has not exceeded its capital expenditures, requiring the company to fund its expenses from other sources (Exhibit 1).

Exhibit 1

The credit freeze makes it rather difficult for the company to raise any cash in the new issue market, forcing it to rely on the remaining balance of loan commitments. Management proactively decreased expected capital expenditures to meet the drop in oil prices; however, they based their decrease on a crude price of US$60/Bbl. Crude now trades US$42/Bbl and we do not believe cash from operations will be able to meet the reduced capital expenditures.

As of September 2008, Pioneer had US$775m of unused borrowing capacity. If the recession continues through 2009, we see the company having to draw down on the loan facilities, leaving them with little room to maneuver.

Since earlier this year, Pioneer's market cap dropped by 77%. Exhibit 2 shows the time series of the company's total debt-to-market cap.

Exhibit 2

The drastic change in leverage is a clear sign of danger, as the company will have an extremely difficult time raising capital in either the equity or debt capital markets. The rate of change of Pioneer's leverage is one of the worst in our entire non-financial universe.

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

The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit). Exhibit 3 lists all the factor scores for Pioneer. We see a 'fair spread' of 1400bp for its poor liquidity, change in leverage and free cashflow factors.

Exhibit 3

In addition to the new liquidity factor, we recently added a change in leverage factor to the model. The addition allows the model to capture the speed at which a company's positioning is moving. The current market is in such flux that we felt a factor such as this is necessary.

Our credit model has been bearish on Pioneer's credit spread since August 2008. Exhibit 4 shows a time series of Pioneer's spread and expected spread.

Exhibit 4

In recent weeks, its expected spread jumped massively wider. This signals a good opportunity to go with the momentum of its rising credit spread and short Pioneer's credit.

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

Summary and trade recommendation
The World Bank and the US Energy Department issued gloomy reports last week on the oil market. Both forecasted substantial drops in global oil demand over the next few years, erasing any hopes of a revival to the commodity boom.

In answer to the reports, we suggest buying protection on Pioneer Natural Resources. Our credit model recently turned sharply bearish on Pioneer's credit spread and the company's management is not prepared to weather such a long and harsh storm.

In their recent earnings call, management dialled down earnings expectations, as well as expected capital expenditures for 2009 in order to adjust to the current oil market. They believe the company will be able to generate enough cashflow from operations to fund expected expenditures; however, this was based on a forecasted oil price of US$60/Bbl.

With crude sitting just above US$40, the company will likely need to draw on remaining loan commitments under an already strained liquidity position. Pioneer's total debt-to-market capitalisation has shot through the roof in the past few months in response to the drastic drop in oil prices, leaving it with little room to raise capital in either the equity or debt capital markets. Not an enviable position.

Buy US$10m notional Pioneer Natural Resources Co 5 Year CDS protection at 580bp.

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).