Contents

Real Estate

Cramdown calamity

Valuations and losses expected to worsen if bill is passed

The US Congress last week introduced legislation to permit bankruptcy cramdowns, thereby enabling judges to permanently reduce mortgage balances in line with a property's fair value. The move - which prompted a sell-off in the Markit ABX and CMBX indices - has been widely criticised by structured credit investors, who fear that it could worsen valuations and lead to even more losses.

"There is no upside to the cramdown bill - it could serve to expedite the decision-making process, but the bottom line is that if you begin destroying contract law, you're destroying the foundations of securitisation," explains one US-based portfolio manager. "And the only alternative to securitisation is for the government to increase its loan limits to provide a fair refinancing landscape for all borrowers - which is essentially reconstituting the GSEs all over again."

Clear moral hazard is associated with the legislation in that it encourages borrowers to take a decision - to become bankrupt - that normally has negative connotations. Combined with possible foreclosure moratoriums, bankruptcy cramdowns essentially favour owners that can't afford to pay over renters (via loan modification) that are paying something that better matches their income - which at least means that some cashflow is maintained.

The portfolio manager suggests that Citi's involvement with the legislation (it reached an agreement with Congressional Democrats to restrict the new rules to existing, but not future, loans) could also be a question of moral hazard, given the extent of support it has received from the government. "Even limiting cramdowns to existing loans won't help in the long term because it sets a precedent that makes it harder for securitisation to recover in the future," he adds.

An additional issue is how the judicial system will cope with a potential flood of cramdowns. One structured credit investor anticipates a significant risk that bankruptcy judges will be so overwhelmed that they'll develop some pro forma standard to manage, meaning that NPV analysis will be ignored.

"The cramdown legislation smacks of wilful negligence: political decision-making appears to be operating at a localised level where no-one is prepared to make principled bigger-picture decisions," the investor argues. "The end result is a barbell effect on the mortgage market, where the middle of the home capital structure (those who are eligible for an agency-backed mortgage) has financing accessibility, but borrowers on either side (prime who exceed agency limits and sub-prime categories) don't. One caveat is that, with many servicers having laid off lots of their staff, not all agency refi applications are likely to be fulfilled."

The stated goal of the cramdown legislation is to reduce REO inventories and thereby rescue the US housing market. Barclays Capital REO/HPA model indicates that such a goal can be achieved if 40% of loans are modified, redefault rates are low and no-one files for bankruptcy except those who would otherwise fall into foreclosure. Under this set of assumptions, remaining depreciation in California (the bank's illustrative housing-bust state) would be only 13%, compared with 31% in its base case.

However, none of these assumptions appears realistic, according to Barclays Capital head of US ABS/CMBS strategy Glenn Boyd. "Given the reduction in moral suasion exemplified by cramdowns, we believe a 50% increase in the rate at which current borrowers go delinquent or file for bankruptcy is plausible," he says. "Further, a large proportion of borrowers are likely to fall behind on their bankruptcy plan, given historical experience. Assuming that 20% of loans are modified effectively, our REO/HPA model projects a 32% remaining decline in California home prices - essentially unchanged from our base case."

If legislation and borrower behaviour is more benign, a 40% modification rate with only a 25% increase in defaults would lead, in the BarCap model, to 24% remaining depreciation. Thus, cramdown legislation will probably fail to mitigate the housing downturn dramatically, but rather spur asset deflation in MBS and consumer ABS, while simultaneously retarding the flow of private-sector credit.

Boyd adds that the details within any potential cramdown bill are extremely important. "A restrictive approach focusing on non-traditional borrowers who make good-faith attempts to negotiate with servicers could minimise moral hazard, foster more aggressive modifications and modestly improve the outlook for housing. As the current bills stand, however, mortgage cramdown appears to be a very negative turn for securitised markets, with weak prospects for supporting home prices," he concludes.

CS

Real Estate

Liquidity regained?

Plans to revitalise CMO trading get go-ahead

Proposals aimed at breathing new life into the CMO sector have been given the green light by industry members, with new reverse-engineered securities expected to start trading by the end of the month. The initiative is designed to provide a floor for pricing in the asset class, as well as boosting liquidity.

The executive committee of SIFMA's MBS and Securitised Products Division last week approved a revision to the Good Delivery Guidelines for TBA (to be announced) MBS trading, which will be effective for CMOs issued by Fannie Mae, Freddie Mac and Ginnie Mae. Fannie Mae will be the first GSE to offer a service (from 28 January), whereby it will reverse-engineer CMOs into TBA-tradable pass-through certificates - a more liquid alternative to their current form. Freddie Mac and Ginnie Mae are expected to follow suit in the coming weeks.

The idea - which has, on the whole, been warmly welcomed by the trader community - was spearheaded by bankers at Merrill Lynch. The implementation of the new plan does not come without its complications, however.

In order for a CMO to be eligible for good delivery into a TBA transaction, it must meet a number of criteria. These include: cashflows on the security must be identical to the cashflows from the underlying loans; all collateral underlying the original REMIC classes that are being recombined must have been eligible for TBA delivery when that collateral was originated; new pass-throughs issued through the re-REMIC process must be issued without OID (original issue discount); and any clean-up calls on underlying collateral must be waived or otherwise eliminated by the GSEs.

Chris Killian, associate director at the American Securitization Forum, confirms that asset managers, dealers or banks that hold CMO tranches will have to assemble their required pieces so that their bonds reflect exactly the cashflows of the underlying loans. "For example, if there was a three-tranche CMO issued and the holder of, say, 20% of one tranche can get hold of 20% of the other two tranches, they'll get bonds representing 20% of the underlying collateral. They will take those to the GSEs and will have them re-REMIC'd. That re-REMIC will be placed into a trust and the trust will issue a new pass-through certificate," he explains.

The new certificate will most likely have a different prefix, even though the cashflow on the new series will be the same as the cashflows on a traditional pass-through certificate. "It's really a liquidity issue that the restructuring of the CMOs is addressing," continues Killian. "The CMO market is pretty sluggish right now, so this initiative will serve to - at a minimum - provide a floor for pricing on CMOs (eligible ones) and increase liquidity."

But not all CMOs will realistically be able to be re-REMIC'd by the GSEs - some agency CMOs are issued with as many as 45 tranches - so in those cases it will not be possible to pick up one of each tranche in order to reflect underlying cashflows. "However, it should be an effective and relatively straightforward process for simpler structures," Killian concludes.

AC

CDS

Positive beta

Further pressure on sovereign CDS expected

Italian five-year sovereign CDS and the Markit iTraxx Crossover index have been highly correlated for a year, reflecting the fact that euro-sovereign bonds typically rely on local sustainable revenue generation for their long-term relative value. Now though, analysts are expecting what happens to credit more widely to have a greater impact on euro-sovereign spreads.

A positive beta (at 98% correlation) between Italian CDS and the Crossover index means that what happens in one market tends to be reflected in the other, according to UBS derivatives strategist Meyrick Chapman. The high/persistent correlation between the two markets is driven by the fact that buyers and sellers have a strong communication network and share the same concerns.

In the case of Italian CDS, credit concerns regarding the probability of default (due to an unsustainable government deficit) occur at around the same time as they do for Crossover names. However, Italy is unlikely to default within the same timeframe as defaults in the Crossover index - although, if many corporates do default, banks will inevitably be hit and this shock will be transmitted to those governments that support banks.

"Any government that has guaranteed banks could in theory be impacted, but we've picked Italy as an example because price movements are incremental (whereas Germany's, for example, are more jerky) and therefore the transmission of information from the credit world to sovereigns is smoother," explains Chapman.

He adds: "What is interesting is that this is having such a major effect; in other words, the idiosyncrasies of the Italian government are being masked by the general communication of credit concerns, serving to amplify concerns that are already there. The question is whether this will continue or whether there will be some idiosyncrasies dominating how Italian CDS trade?"

For example, the Crossover index could potentially experience fewer defaults than anticipated and rally, with Italian CDS spreads remaining at their high levels or even rising further. "Although it won't be very obvious over a period of, say, a year, it is possible to envisage some room for divergence between the two - especially if the long-term economic environment is dominated by low growth and low inflation (the best scenario for Italy would be high growth and low inflation)," notes Chapman.

The market is seeing some divergence between German and Italian CDS spreads, with asset swap levels already equivalent to the historic peak seen in the Crossover index in December. Chapman says the fact that swaps are beginning to outperform bonds indicates that the European market is already building in bad news.

"This has happened in spades in the US because, although the market has seen significant issuance, it is indistinguishable from guaranteed bonds," he concludes. "But it has taken a long time to occur in Europe. Italian asset swaps are high now, indicating that the market already assumes the Italian government is more prone to shocks than other sovereigns. We do not see much further upside, but we do wonder if similar concerns could now spread to so-called core issuers."

CS

CLOs

CLO spreads stable as distressed appetite emerges

Trading in the structured finance secondary markets got off to a positive start on both sides of the Atlantic last week, with improved sentiment and demand seen in the CLO sector. Secondary CLO pricing has now been stable for the sixth straight week, while spreads on highly-rated US consumer ABS rallied significantly (by between 25bp-100bp on triple-As), led by the credit card sector.

However, the lack of availability of preferred paper remains a headache for traders and brokers. Structured credit strategists at JPMorgan suggest that a significantly growing number of distressed fund investors now want to put cash to work, but it remains to be seen whether prospective sellers wish to meet this demand and crystallise some US$15-US$20bn of losses based on current triple-A levels.

Current secondary pricing levels for CLOs, according to JPMorgan, are 500bp, US$40, US$20, US$15 and US$10 for triple-As, double-As, single-As, triple-Bs and double-Bs respectively.

AC

Indices

Two-month low for counterparty risk

Counterparty risk fell to a two-month low last week as US and European governments' various facilities appeared to be effectively reducing systemic risk in financial institutions, according to Credit Derivatives Research. The CDR Counterparty Risk Index (CRI) has fallen for three straight weeks - for the first time since July 2008 - with the latest week showing the largest improvement since the October 2008 capital injections in Morgan Stanley, dropping over 20bp (or 13% less risky).

The current CRI is now considerably below the highs of the Bear Stearns fallout weekend and also below the post-Morgan Stanley capital injection and WaMu/JPMorgan merger weekend levels (see SCI data). However, CDR chief credit derivatives strategist Tim Backshall notes that counterparty risk is still over three times higher than when the initial broker losses and Bear Stearns hedge fund failures came to light, and twelve times higher than at the start of 2007.

AC

Ratings

Growing risks addressed in European deals

Fitch is developing two new criteria reports in response to growing risks within many European structured finance transactions, both in the nature of the collateral being securitised, as well as the extent of counterparty risk involved.

The first addresses the topic of rating ceilings and outlines circumstances where the maximum structured finance rating that can be obtained within a structure will be capped, as a result of the nature of the underlying risks. The second is a revision to Fitch's counterparty criteria and will address mitigants that might be adopted to minimise the risks associated with counterparty exposure and reduce the potential instability that this might bring to structured finance ratings or an originator's rating.

Fitch estimates that the average European structured finance transaction size (excluding CDOs) was €2.6bn in 2008, compared to €1.7bn in 2007, as banks continue to tap central bank repo facilities. The agency says that banks are also increasingly looking to the remaining assets in their back books. In some cases these assets have been passed over for securitisation until now because they have been deemed too problematic or costly to securitise in terms of limited data availability, legal concerns, systems issues or enhancement levels.

AC

Trading

Mortgage credit trades recommended

US securitisation research analysts at Barclays Capital have identified four trades that they believe will offer attractive returns across a range of potential scenarios based around three key themes for mortgage credit in 2009.

"While base-case yields look reasonably healthy across residential credit, ongoing uncertainty in performance and legislation, combined with bad technicals, will present very compelling trades down the road," they argue.

The analysts believe that fundamental performance versus expectation will be the most significant factor driving sustained rallies or sell-offs in 2009. In addition, understanding the government's evolving role on the modification/legislation front will be of paramount importance.

The first trade the analysts recommend is going long 2006-2007 vintage Alt-A hybrid/negative-amortising super-seniors and negative-amortising first sequentials because they are expected to withstand 50%-60% bond loss without a deterioration in yields. Secondly, going long third cashflow/last cashflow bonds from 2007-vintage implied write-down sub-prime deals is recommended as a defensive trade to protect against very dire scenarios, such as cramdowns.

Thirdly, the analysts prefer 2006-vintage Alt-A negative-amortising/hybrid super-seniors over 2007-vintage super-seniors because the built-up enhancement in the deals should be worth 4-6 points. Finally, paying up for higher refi-eligible pools is recommended, with security selection potentially adding 3-5 points to prices as tiering of refinanceable pools (into agency/FHA loans) emerges in 2009.

CS

Investors

Seeking sustainable returns

Indranil (Neil) Basu, managing partner of Pearl Diver Capital, answers SCI's questions

Neil Basu

Q: When did your company become involved in structured credit?
A: Pearl Diver Capital came together in September 2008, to take advantage of the dislocated credit markets. The objective is to build a business around a thorough understanding of corporate credit and provide investors the opportunity to participate in corporate credit, either directly or through derivatives of corporate credits, such as CLOs and corporate credit securitisation tranches.

The team brings together skills in structured credit products and leveraged loan/corporate credits, and spun off recently from Wachovia's European Structured Finance unit. The members have significant expertise from diverse buy- and sell-side firms, including Nomura, Deutsche Bank, Citi, John Hancock and BNP Paribas.

Our team adds value through a number of aspects: rigorous loan-by-loan re-underwriting capabilities in leveraged loans; structural analysis skills with proprietary analytical models; deep industry contacts; relative value trading skills through secondary trading; special situation investments; and participations in restructuring and re-rating of transactions to protect or optimise investments.

Q: What, in your opinion, has been the most significant development in the credit market in recent years?
A: The last seven years from 2002 to 2008 can be broken up into two separate chapters, with the first five years until the end of 2006 seeing unprecedented growth in leveraged loan financing to private equity sponsor-led transactions, fueled by a growing appetite from a new class of institutional investors, namely the CLO/structured credit products vehicles.

From mid-2007 until the end of 2008, the market dislocation that primarily began with CDO/structured products backed by US sub-prime mortgages led to an unprecedented deleveraging in the financial markets, hedge fund redemptions and liquidations of market value structures. This in turn drove valuations of leveraged loan downwards from near par to as low as 70 cents on the dollar.

The lack of availability of cheap leverage effectively closed down the primary CLO issuance market, completely removing a significant investor base for leveraged loans. Combined with a growing recession in the US and Europe, default expectations in leveraged loans have now risen to 25%-30% for the next four years, with lower recovery expectations. CLO tranche valuations have fallen across the board, with triple-As trading in the 70-80s, mezzanine tranches anywhere from 15-30 cents on the dollar, while equity trades are occurring between 5-15 cents on the dollar.

Q: How has this affected your business?
A: The drop in CLO tranche valuations has been across the board and has tainted performing CLOs managed by top-tier managers with the same brush as non-performing CLOs from tier-two managers. This presents a unique opportunity for investors who are looking for exposure to the leveraged loan asset class, and our business is built around this central theme.

Q: What are your key areas of focus today?
A: Our current fund seeks to invest in CLO tranches that represent significant value due to current market prices, while benefiting from structural protections that allow for sustainable returns under very harsh default scenarios.

Q: What is your strategy going forward?
Going forward our objective is to build a sustainable asset management business around the corporate credit asset (both speculative as well as investment grade) class. Our aim is to provide investors with the ability to participate in this class directly or through derivatives, taking advantage of any relative value that may exist.

We are not a hedge fund, employ no leverage and our funds are not subject to redemption features that plague hedge funds. We will continue to focus on raising private equity-style long-term institutional capital that is more geared towards the illiquid asset classes that we are active in.

Q: What major developments do you need/expect from the market in the future?
A: The deleveraging process that started in 2007 is expected to continue into 2009 and early 2010. The current recession is consumer-led and over time, as economies start to come out of this, we would like to see a stabilisation of asset values and improvement in employment statistics - leading to the re-emergence of investments (government-led) and spending (consumer-led). This would in turn provide the impetus for growth and fresh corporate lending activity.

About Pearl Diver Capital
Pearl Diver Capital is a structured finance asset management company backed by stable and long-term private equity-style institutional capital. Within the global structured finance arena it specialises in finding and capturing the rare and resilient nacre of value that only a select few are poised to exploit. Pearl Diver Capital is regulated and authorised by the FSA.

UniCredit pair joins asset manager

The latest company and people moves

UniCredit pair joins asset manager
Jochen Felsenheimer has joined independent European financial asset and risk manager Assenagon Group as co-head of credit, responsible for all of its credit activities. The firm offers advisory and risk management services, as well as structured fund solutions for institutional and retail clients.

Felsenheimer was previously md and head of credit strategy and structured credit research at UniCredit. He is joined at Assenagon by UniCredit colleague Wolfgang Klopfer.

Structured credit head appointed
Swiss Re has appointed Pat Augustine as head of structured credit and securitised products, based in New York. Augustine was previously global head of structured products at Bank of America.

Distribution head moves to buy-side
Declan Tiernan is understood to have been appointed md at Sciens Capital Management. Tiernan was previously head of structured credit distribution at Deutsche Bank in London, but left towards the end of last year.

Leveraged finance md hired
Ares Management has hired Greg Margolies as a senior partner and head of the firm's capital markets group. He joins Ares from Merrill Lynch, where he was md and head of global leveraged finance and capital commitments, as well as a member of the executive committee of the investment banking group. Prior to joining Merrill Lynch in 2003, he held senior positions investing in leveraged finance products at both Deutsche Bank's DB Capital unit and the Carlyle Group.

Correlation trader joins broker
Deval Bhalja, former correlation trader at Bank of America, is understood to have joined BGC Partners for a CDO sales role. He will cover both cash and synthetic products.

Trading co-head on the move
Boaz Weinstein, co-head of global credit trading at Deutsche Bank, is believed to be leaving the bank - along with 15 other members of staff - to set up a hedge fund. The other co-head, Colin Fan, will become sole global head of credit trading at the bank.

Correlation role filled
Dario Villani has reportedly joined Deutsche Bank as md in credit trading, focusing on correlation. Villani moves over from Merrill Lynch, where he worked in the global strategic risk group.

Derivatives lawyer hired
Alaric Compliance Services has appointed Christopher Lewis, previously a partner at Thacher Proffitt & Wood, as general counsel and director. Lewis specialises in derivatives, capital markets, distressed assets and regulatory compliance. He has participated in numerous ISDA Committees and negotiated hundreds of derivatives agreements.

Trading head appointed
Standard Chartered Bank has appointed Mohammed Grimeh to the newly created role of head of trading and deputy head of global markets, Americas. He will be responsible for managing foreign exchange, interest rate, credit and commodities trading across G10 and emerging markets. He will also be responsible for broadening the bank's trading platform in the Americas.

He joins Standard Chartered from Lehman Brothers, where he had been global head of emerging markets since 1998.

S&P hires to boost rating strategy
Ray Groves, former Ernst & Young chairman and ceo, has been appointed as the ombudsman for S&P, effective 16 February. His appointment is one such initiative the rating agency is taking to strengthen its ratings process, increase transparency and better serve capital markets around the world.

In his new role Groves will address issues and concerns raised from both within or outside the company confidentially, while also ensuring that all channels within the company are effectively utilised to resolve those issues. The ombudsman will report outside of the S&P business units to Harold McGraw, chairman, president and ceo of The McGraw-Hill Companies

High yield funds reorganised
The board of directors of the High Yield Income Fund, the High Yield Plus Fund and the Dryden High Yield Fund have approved separate proposals whereby the assets and liabilities of the High Yield Income Fund and the High Yield Plus Fund will be exchanged for shares of the open-ended Dryden High Yield Fund.

The High Yield Income Fund's manager is Prudential Investments, while the High Yield Plus Fund's investment adviser is Wellington Management Company.

Under the proposals, shares of the High Yield Income Fund and the High Yield Plus Fund would be exchanged at net asset value for Class A shares of equivalent value of the Dryden High Yield Fund. Shareholders of the High Yield Income Fund and the High Yield Plus Fund would consequently become shareholders of the Dryden High Yield Fund. No sales charges would be imposed on each proposed share issuance.

Each plan of reorganisation is subject to approval by the shareholders of the funds. Shareholder meetings are expected to be held in May.

Financial regulation centre opened
The International Centre for Financial Regulation (ICFR), an independent global research institute focused entirely on financial regulation, launched earlier this week in the City of London. Barbara Ridpath has been named chief executive.

The ICFR, the first of its kind, is the product of a unique cooperation between 19 financial services institutions, the City of London Corporation and HM Government to provide objective, non-partisan research, debate and training on financial regulation.

The ICFR will commission research to move forward thinking on regulatory frameworks and will also commission training to improve regulatory understanding, compliance and risk management. The ICFR will work in collaboration with existing bodies and standard setters providing financial training to create 'best in class' tailored provision for market participants, policy makers and regulators. The Centre, while based in London, is intended to serve constituencies well beyond the borders of the UK, aiming to provide a secure international forum for open dialogue on effective regulatory collaboration and best practice.

AC & CS

US home price declines ease

A round up of this week's structured credit news

US home price declines ease
LoanPerformance November HPI data shows cumulative home price declines since mid-2006 standing at -27.42% compared to -26.42% last month. The 12-month HPI was -16.74% in November, a slight improvement from the previous months' figures in the -17% to -18% range.

JPMorgan structured finance analysts' preliminary read of November home price declines was -7.88% annualised, or -3.06% seasonally-adjusted. Incorporating projections for further downward revisions, they expect the terminal seasonally-adjusted number to be -10%. As a comparison, October one-month seasonally-adjusted annualised HPA was -12.24%.

The LoanPerformance and Case-Shiller home price indices have been decoupling over recent months, driven by different seasonal adjustments, most notably for September and October. While the JPMorgan analysts adjust LoanPerformance data for these months up by around 4% and 6% respectively, Case-Shiller data is kept roughly unchanged. They expect the Case-Shiller index to start showing the same trend as LoanPerformance in the coming months, since the LoanPerformance HPI tends to be a leading indicator of Case-Shiller.

iTraxx rally short-lived
A bullish tone in the Markit iTraxx index was sustained to the end of last week, with the Main reaching 156bp versus 180bp recorded at the beginning of the week, and in contrast to levels of 220bp seen in early December. However the rally came to an abrupt end on Monday, with spreads drifting several points wider.

Credit strategists at UniCredit comment that an ugly earnings season could reverse rallies in the iTraxx. "Especially in the banking segment, the disastrous fourth quarter - which included the impact from the Lehman collapse and all subsequent defaults - will be a bummer. We expect that spreads will come under pressure again once the corresponding headlines hit the screens in the coming weeks," they say.

CDPC operating guideline changes get go-ahead
Channel Capital's proposal to exceed some of its CDS portfolio limits will not result in its counterparty rating or the ratings of its issuance being downgraded or withdrawn, says Moody's. The proposed amendment to Moody's version of the operating guidelines for the CDPC would permit Channel to exceed CDS portfolio limits in aggregate obligor exposure, industry concentration limits, geographic concentration limits, notched ratings limit, tenor limits and individual obligor notional limit.

Basel Implementation Group to broaden focus
The Basel Committee on Banking Supervision is set to broaden the mandate of its Accord Implementation Group (AIG) from the current focus on implementation of the Basel II framework. The AIG will be renamed the Standards Implementation Group (SIG) and will concentrate on implementation of Basel Committee guidance and standards more generally, including supervisory colleges and home-host issues. The group will continue to be chaired by José María Roldán, director general of banking regulation at the Bank of Spain.

Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, says: "The financial crisis has highlighted the importance of prudent, well-informed standards and supervisory guidance. The SIG will work to promote implementation of all Basel Committee standards in an internationally coordinated and consistent manner."

First European LCDS auction called ...
ISDA is to launch a CDS auction protocol to facilitate the settlement of Sanitec LCDS trades. This will be the first European leveraged loan credit event auction.

Markit iTraxx LevX market-makers voted to hold an auction for loan-only CDS transactions referencing Sanitec, after the company missed interest payments on senior loans used to finance its acquisition by EQT in 2005. Sanitec is a constituent of the LevX index.

... while Lyondell ...
Markit LCDX index dealers have voted for a credit event auction to facilitate settlement of LCDS trades referencing Lyondell Chemical Company - a constituent of the index. Meanwhile, ISDA is launching a CDS auction protocol to facilitate the settlement of credit derivatives trades (other than loan-only CDS transactions) referencing three entities in the LyondellBasell group.

The three entities are Lyondell Chemical Company, Equistar Chemicals and Millennium America Inc. LyondellBasell Industries announced on 6 January that in order to facilitate a restructuring of its debts, its US operations and one of its European holding companies - Basell Germany Holdings GmbH - have voluntarily filed to reorganise under Chapter 11 of the US Bankruptcy Code.

... and British Vita auctions arranged
ISDA will launch a CDS auction protocol to facilitate the settlement of European loan-only credit default swap (ELCDS) trades referencing certain loan obligations of British Vita (UK), the chemicals company.

ELCDS transactions refer to reference obligations rather than reference entities, as is the case in regular CDS and North American LCDS. In accordance with the ELCDS auction rules, Markit iTraxx LevX market-makers have determined that the reference entity (which term includes TPG Spring (UK), the 'Borrower (Example)' for the reference obligation in the Markit database, together with all other borrowers and obligors in relation to the reference obligations) has failed to make payments due on some or all of the reference obligations (also listed on the Markit database) and have voted to hold an auction for ELCDS transactions referencing any of those reference obligations.

ISDA will also publish a protocol to update legacy trades (i.e. those single name trades based on previously published ISDA documentation and LevX Series 2 trades) and certain other single name and LevX Series 1 trades on Sanitec and British Vita only, which will be open to ISDA members and non-members alike.

Pivotal year ahead for accounting
2009 will be a pivotal year for accounting, particularly in relation to fair value and convergence of US GAAP and IFRS, Fitch says in its 'Accounting and Financial Reporting 2009 Global Outlook'.

"The global economic environment coupled with increased regulatory and political scrutiny have presented numerous challenges to the interpretation and implementation of some pervasive accounting issues," says Olu Sonola, director in Fitch's Credit Policy Group. "While it is highly unlikely that fair value accounting will be reversed, it is increasingly clear that there will be additional refinements to temper some unintended consequences [see last week's issue]."

Fitch believes that fair values are helpful to analysts and investors when they represent realistic and reliable indications of the net present values of future cashflows.

As companies prepare their full-year 2008 financial statements, a pressing question is how best to justify a going concern basis, given the doubts some have about their ability to refinance. Impairment of debt investments and the lack of clear-cut rules on the subject have pitted some issuers against their auditors. This, according to Sonola, "is a particularly sensitive issue when not only profitability but also regulatory capital adequacy is at stake for many financial institutions".

The business combination standard may add volatility to an acquirers' income statement. Fitch also expects new accounting rules on special purpose entities to bring many off-balance-sheet entities back onto US companies' balance sheets.

"Outside the US, new segment reporting under IFRS will need to be explained well if analysts are to understand the financial performance of a company, given everything else that is happening," comments Fitch md Bridget Gandy.

A positive development for analysts and investors is that disclosures are set to improve on multiple fronts. Fitch expects disclosures on credit derivatives, fair value and off-balance sheet entities to become more meaningful, particularly in the US.

CLO rating changes following restructure
Fitch has upgraded two and downgraded three classes of notes issued by Fall Creek CLO, following a restructuring of the transaction. The deal was amended and restated to remove the market value-based threshold value event (TVE) trigger, effectively converting Fall Creek into a static cashflow transaction structure from the original market value CLO structure.

Under the previous structure, the issuer was unable to cure the failure of the TVE trigger. The ongoing failure would have resulted in the liquidation of the asset portfolio, but it was believed that the liquidation proceeds would have been insufficient to redeem all of the notes outstanding.

CMBS map to recovery released
DBRS has released a commentary on the commercial mortgage market and its map to recovery. With an annual total of US$12.15bn, 2008 US CMBS issuance volume is down 95% from its record high volume in 2007, representing the lowest issuance volume since 1991.

"Since late 2007, the CMBS market has been waning and conduit lending as we know it has ceased," says Jack Toliver, md - global CMBS at DBRS. "If CMBS and other forms of securitisation are to remain a viable product in the future, industry participants need to look past the blame game and assume accountability to identify the necessary components to establish a foundation upon which to build a platform for recovery."

In conversations with industry participants, DBRS has found that the most compelling discussions included what it calls the 'four planks in the platform for recovery':

• Don't expect a government bailout.
• Identify and support the unassailable.
• Improve transparency.
• Maintain the rule of law.

It is DBRS's belief that if the market focuses on the four planks of recovery, the commercial mortgage industry will come back stronger than before and the foundation will be far more stable

300% y-o-y increase in CDS tear-ups
CDS terminations witnessed a 300% increase in notional volumes compared with 2007 levels, according to TriOptima, whose portfolio compression service triReduce eliminated US$30.2trn in CDS notional principal in 2008. TriOptima offered 50 compression cycles in 2008, contributing to industry efforts to reduce notional principal outstandings.

"It is important to note that the US$30.2trn notional eliminated by the dealers this year exceeds the year-end outstandings of US$29.3trn reported by DTCC," says Brian Meese, group ceo. "By reducing exposures through regular compression cycles the dealers were able to continue providing effective risk mitigation tools while responding to regulatory concerns about counterparty exposure and operational challenges."

TriOptima's CDS compression cycles include American, European, emerging market, Asian and Japanese indices; ABX and CMBX indices; American and European tranches; US, European, emerging market, Japanese and Asian single name CDS; and special cycles for single names and indices affected by credit events.

Q408 new issuance figures in
New data from Xtrakter shows that 2008 total fixed income new issuance was valued at US$3.4trn, representing a 15.2% (US$453bn) rise on 2007 figures. Asset-backed new issuance accounted for 25.7% (US$883bn) of all issues during the year.

The top-10 issuers in 2008 were: Federal Home Loan Banks (US$155.8bn), RBS (US$115.9bn), Lloyds TSB (US$96.7bn), Fannie Mae (US$95.3bn), KfW (US$95bn), HBOS (US$93.8bn), Barclays Bank (US$90.5bn), Freddie Mac (US$68.3bn), GE Capital (US$65.3bn) and the European Investment Bank (US$54.1bn).

Analysis of Q408 figures against those of Q407 showed that fixed income new issuance rose by 28.4% (US$188bn) to US$852bn and asset-backed new issuance rose by 190% (US$232bn) to US$354bn, representing 41.5% of all issues for the quarter.

'Points upfront' primer published
With idiosyncratic stress set to grow in 2009, a familiarity with the 'points upfront' format will be essential for all CDS users, according to quantitative credit strategists at Barclays Capital. The strategists have published a comprehensive primer intended as a practical toolkit for portfolio managers, traders and risk managers.

While rigorous, the focus is on intuition rather than mathematics, they say. Topics covered in the primer are divided in three areas:

• Why do CDS switch to trading upfront when spreads are high? This is broken down into three parts: improved performance of discount bond hedging; higher predictability of cashflows; and attractive trading properties such as easier marking-to-market, unwinds and risk management.
• Converting between running and points upfront A discussion of basic relationships, formulas and terminology, covering the uses and limitations of Bloomberg CDSW and detailing the impact of curve and recovery assumptions.
• Properties of upfront contracts A variety of often overlooked properties affecting the trading and management of upfront CDS include: changes in sensitivities, funding and counterparty risk profile, impact on the economics of basis packages, analysis of upfronts term structure shapes and intricacies of upfront curve trades.

Credit portal expanded
Given the rapidly changing investment landscape and the evolving credit needs of financial professionals, S&P has upgraded its RatingsDirect Global Credit Portal. The new solution will integrate seamlessly into investors' workflow and help to efficiently perform credit risk-driven analysis, the agency says.

Incorporating feedback from thousands of RatingsDirect users worldwide, the offering:

• Aggregates intelligence at the sector, sub-sector and industry level with critical insights, including recent developments, ratings migrations and distributions, biggest movers by CDS spreads and industry snapshots
• Offers deep-dive data at the entity, instrument and deal level for structured assets, including expanded collateral and performance data and graphical views of deal participants
• Compares S&P credit ratings to S&P derived ratings that incorporate CDS spreads
• Provides additional research content based on market movements and views including S&P's market, credit and risk strategies and Leveraged Commentary & Data
• Enables enhanced portfolio surveillance with user-directed tracking and peer comparison tools
• Facilitates the process of monitoring developments on specific credits with the ability to integrate third-party news from the trade press, industry media and corporations.

DTCC to support all CDS CCPs
The DTCC says it will support all central counterparty (CCP) solutions for CDS, in a non-discriminatory manner, with its Trade Information Warehouse - whose capabilities include central net settlement and asset servicing. Through its DTCC Deriv/SERV subsidiary, the company is currently working with ICE Trust/The Clearing Corporation, CME/Citadel, LIFFE/LCH and Eurex to facilitate their efforts to provide CCP services trade guarantees for CDS.

Peter Axilrod, md, business development and Deriv/SERV at DTCC, comments: "By utilising the Warehouse's post-trade processing infrastructure rather than investing valuable resources to build their own, CCPs can achieve the objectives of CCP clearing - that is, to mitigate and mutualise counterparty risk and increase market liquidity - at the lowest cost and the greatest efficiency to their CCP members. Our support of CCP providers will give the industry standard centralised asset servicing across both cleared and bilateral trades."

LSS model amended, notes downgraded
S&P has downgraded eight spread-based leveraged super senior (LSS) notes following the recalibration of the model it uses to rate these transactions. Specifically, the rating agency has increased the volatility parameter it uses when simulating spread paths.

In future, S&P will use CDO Evaluator v4.1 and a volatility parameter of 60% to model all LSS transactions that have spread triggers. Before this recalibration S&P used a volatility parameter between 35% and 40%. The change recognises the increased volatility of CDS spreads that has occurred over the past 12 months, the agency says.

The downgraded LSS notes are issued by Claris, Eirles Two, Motif Capital, Sceptre Capital, REVE SPC and Credit and Repackaged Securities.

CBO completed
Moody's has assigned definitive ratings to Roof Global Bond CBO 2008-2, a US$752m transaction backed predominantly by senior unsecured and subordinated bonds from banks and financial institutions in the US, United Arab Emirates and the UK. Raiffeisen Zentralbank Österreich arranged the deal. The deal is rated by Moody's.

Rationale behind private ratings explained
The rationale behind S&P's decision to offer private ratings for certain newly-underwritten European leveraged transactions is examined in a new report entitled 'Credit FAQ: Private Loan Ratings For European Leveraged Finance'. The report addresses the most frequently asked questions the agency has received since announcing in July 2008 that it would offer private ratings for European leveraged finance transactions where the total debt (funded and unfunded) is less than €1bn (see also SCI issue 88).

"The overriding objective of this initiative, which took effect on 1 December 2008, is to improve the quality and depth of ratings support for leveraged loans that are aimed at, or held by, institutional investors," says S&P credit analyst Paul Watters. "Following extensive market consultation last year, it became clear that the option of private ratings for mid-market transactions would address certain key concerns. These concerns included the potential impact of public disclosure of the ratings on the private equity business model, as well as the more widely shared concern that the provision of public ratings could lead to a reduction in the quantity and quality of information provided to the lender group."

As the report points out, the main changes in S&P's approach to ratings for the European leveraged finance market are that:

• Only public ratings will be offered for those transactions with total debt facilities of more than €1bn;
• For transactions where total debt facilities are less than €1bn, at the request of the company we will provide public or private ratings, including loan and recovery ratings, on any associated debt instruments; and
• Credit estimates will be restricted to new transactions where total debt facilities are less than €500m.

CS & AC

CDS

Understanding basis for discount bonds - part 1

In the first of this two-part series, Barclays Capital quantitative credit strategists Arup Ghosh, Matthew Leeming and Graham Rennison introduce the Basis Representation Diagram framework in order to examine the full distribution of potential returns

With the prevalence of significantly negative basis packages, the question of how best to measure and analyse cash-CDS basis is particularly pertinent at present. Should a basis measure somehow represent an expected return? Should it signify an annual cashflow? Should it correspond to a worst or best-case return?

No single measure can represent these practical metrics simultaneously and many commonly used measures, such as z-spread minus CDS, correspond to none of them. In order to analyse the basis package thoroughly, it is necessary, in our opinion, to examine the full distribution of potential returns. To this end, we introduce the Basis Representation Diagram (BRD).

Figure 1 is an example of such a representation diagram, where we analyse a negative basis package for a 10.5-year Cable & Wireless bond. This chart plots the hold-to-maturity or hold-to-default return of the package, as a function of the bond's default time.

For example, if default occurs in one year, then holding the package is equivalent to earning 29% over one year on the initial capital. At the other extreme, if the bond survives to maturity, then the package is equivalent to earning a spread of 4% per year until maturity.

We also overlay the CDS-implied default probability, which represents the market-implied likelihood of each return. In this case, the most likely outcome, with 60% probability, is no default.

We find the BRD a very intuitive tool for understanding the basis risk profile for a particular package and also for studying relative value between bonds. As using the full BRD can be complicated to compare different trades, we recommend summarising the key information for such purposes.

Figure 2 illustrates one way to do this, and shows the range of possible returns for each package. Generally, the lower end of the range corresponds to the no-default scenario and the upper end corresponds to short-term default (we choose one year as a reasonable threshold). We also plot the expected return (using CDS-implied default probabilities).

Qualitatively, the higher up the scale the expected return is, the higher the chance of default. Figure 2 admits a very easy comparison between basis packages and, when applied to a large set of bonds, is a powerful tool for identifying interesting basis opportunities for further examination.

In the first half of this report, we expand on these concepts in detail, give several examples and suggest how to condense the information contained in the BRD using just a few measures, which are easy to calculate, for example, by using Bloomberg. In the second half of this report (published in next week's issue), we discuss the impact of other factors, such as funding costs and interest rates.

Measuring the basis using BRD
Ideally, the basis should somehow represent the potential profit of the basis package if held to maturity or to default. For bonds trading away from par, this return is predominantly dependent on one factor: time to default.

For the purpose of this publication, we only consider basis packages constructed as follows:

• Buy one bond
• Buy CDS protection on 100% notional of the bond.

This renders the position free of recovery rate risk. Figure 1 shows an example of the BRD, which represents the basis package return as a function of default time.

Examples of BRD
The BRD approach is best illustrated with real life examples. In order to help develop the intuition, we consider four separate examples using European bonds with different properties:

• Cable & Wireless package: a discount bond with relatively flat CDS curve
• Glencore package (running CDS): a deeply discounted bond, with an inverted CDS curve in all running format
• Glencore package (upfront CDS1): a deeply discounted bond, with an inverted CDS curve in upfront +500bp running format
• Iberdrola package: a bond trading close to par.

Example 1: Cable & Wireless 8 5/8, 2019
As the first illustrative example, we look at a 10.5-year Cable & Wireless bond paying a coupon of 8 5/8 priced at £79. We assume Libor as the cost of funding for the investor, and form the basis package with one bond and 100% notional of CDS, as shown in Figure 3.

It is in fact possible to extract explicitly the information on default timings from the CDS curve. Figure 4 plots both the package returns for different default timings (left-hand axis) and the probability of that scenario being realised (right-hand axis).

In this particular case, it is interesting to see that:

• If there is a default after one year, with probability priced at around 5%, the return is highest, near 30%. The 30% is calculated, for example, from the 21 points earned from delivering the bond (which cost £79) into the CDS contract, together with the roughly 450bp carry earned. These 25.5 points are then discounted back to today and expressed as a return on capital invested, or £79.The most probable outcome priced by the market is that the bond redeems at maturity (60% probability). In this case, the return is low, at about 5%. This reflects the fact that the pull to par is amortised across the full life of the bond.
• The highest probability of default is priced in 2-3 years time, with returns of 10%-15%.

The BRD shown in Figure 4 is highly flexible in that it allows an investor to consider market-implied probabilities of default, as well as overlay their own subjective probabilities and assess returns potential accordingly. An alternative basis representation diagram is introduced in Figure 5.

This diagram shows the distribution of returns on the basis package, with the probability of achieving those returns set by the CDS market. Returns are now shown on the horizontal axis and default time, while not marked, is implicit at each point.

In this case, we see that the distribution is very skewed: the most probable outcome is redemption at maturity, while there is also some likelihood of default in the short term. In fact this returns distribution can be viewed as an interpretation of the basis itself.

Instead of using a single number, as most basis measures do, we use a distribution, which provides far more information. The distribution also helps calculate the expected return of the package, which is 6.7%. It is interesting to note that, while the expected return provides an average estimate of the basis, it does not lie close to either of the two most probable outcomes.

Please also note that the above distribution is discrete and assumes default can occur only at the end of each year. It is of course possible to refine the analysis by assuming default can happen at finer granularities of time.

This second approach to a BRD (we refer to these charts as BRD-2) is helpful for looking at the returns distribution in a more traditional format. We leave it to the reader to decide which they find more intuitive, and switch between methods in various section of this report.

Example 2: Glencore 7 1/8 2015; running CDS
For the second example we analyse a 6.5-year deeply discounted bond paying a coupon of 7 1/8. More interestingly, Glencore has an inverted CDS curve that prices in a high likelihood of default in the short term. Figure 6 summarises all the information on the cashflows of the package.

Using the available information, we plot the basis diagram for the Glencore package as indicated in Figure 7. It is different from the previous package in two ways:

• The market-implied probability of default in the short term is significantly higher, due to the inverted CDS curve, and such an event would yield very high returns.
• The probability of redemption at maturity is lower, but still the most probable outcome.

In this case returns are as low as 10bp. This is due to the fact that, although the pull to par is significant, the value of this is amortised across the life of the bond and the net carry on the position is negative, eating into this profit as each year passes.

It becomes apparent from the distribution that this package has a payoff profile for a different kind of investor compared to the first one. In the case of CWLN, an investor funding at Euribor and holding the package to default/redemption was bound to earn some returns. In the case of GLENCR, the investor receives negligible returns if the bond redeems at maturity, but is compensated through a significant chance of earning very large returns through default in the short term (see Figure 8).

Example 3: Glencore 7 1/8 2015; upfront CDS
When bonds start trading at as wide spreads as Glencore, the market often switches to trading upfront CDS as opposed to running. Figure 9 summarises all the information on the cashflows of the package in such a case.

As we can see, upfront payments add to the initial cost of the package but increase the carry earned. This affects returns both in the long term and the short term, as indicated:

• Returns in case of near-term default are reduced because the upfront payment is much bigger than the running CDS premia that would otherwise be paid in such a short time.
• Returns in case of redemption are increased, as the upfront CDS payment is less than the running CDS premia that would otherwise have been paid over the life of the bond.

This effect of changing from running CDS to upfront is illustrated in Figure 10. It is interesting to note how returns under different scenarios change, even as the market (CDS) implied probabilities of those scenarios remain unchanged.

This is further clarified in Figure 11. While the probabilities of any given scenario remain unchanged (default in one year, two years etc), the distribution has much less dispersion in terms of returns.

Example 4: Iberdrola package 5 1/8 2013
For the last example, we analyse a 4.5-year bond trading close to par and paying a coupon of 5 1/8. Iberdrola also has a relatively tight and upward sloping CDS curve. Figure 12 summarises all the information on the cashflows of the package.

As indicated in Figure 13, the returns expected from this package are quite small, and the market prices redemption as extremely likely.

Figure 14 illustrates how the expected return on this package is almost identical to the returns on redemption. This is because of two factors:

• The market prices in default as very unlikely.
• As the bond is close to par, the returns on short-term default are not much higher than at redemption.

© 2009 Barclays Capital. All rights reserved. This Research Note was published by Barclays Capital on 7 January 2009.

Trading

Trading ideas: housing boom?

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

Homebuilder CDS rallied hard since mid-November and, amid market anticipation of government stimulus spurring new home sales, we now find many industry names trading tight to fair value. After rallying throughout December, Centex Corp (CTX) continues to see its CDS level improve and now sits at six-month tights. Centex's equity is up dramatically since its mid-November lows, but has not kept pace.

This created a disconnect between the company's CDS, equity and implied vol levels and we anticipate a combination of CDS sell off, share rally and a drop in implied vol combined with a flattening of the vol curve. To take advantage of the expected share rally and flattening vol curve, we recommend buying CDS protection and selling equity puts.

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

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

Exhibit 1

Since the end of November, CTX's CDS has outperformed its equity and now CTX CDS trades well below our modeled fair value. CTX also trades well below its expected level according to our directional credit (MFCI) model. We believe market anticipation of government intervention is at play here, but the CDS rally is overdone compared to its equity.

Exhibit 2 charts CTX's current three-month implied vol curve as well as our modeled fair value vol curve. Our CSA model points to a rally in share price and a drop in at-the-money implied volatility. Combining these expected values with CTX's current implied vol curve, we expect to see an overall drop in vol as well as a flattening of vol curve.

Exhibit 2

We choose to sell equity puts to take advantage of both this drop in vol as well as rally in share price (rather than bet on vol or equity exclusively). With this in mind, we chose the liquid strike that we think will give us the best trade economics.

Risk analysis
The main trade risk is if the name begins trading under a different regime and the current vol-equity-CDS relationship no longer holds.

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

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a different 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: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Government actions: Bailouts, stimulus packages and other governmental interventions have distorted the credit-equity relationship among certain names. Part or all of the current perceived credit-equity disconnect may be due to the market's anticipation of government aid.

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

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

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

Buy US$1m notional Centex Corp 5-Year CDS at 355bp.

Sell 115 lots Centex Corp US$10.00 Strike April 09 Puts at US$1.80 (100 multiplier per contract) to pay 355bp of carry.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2009 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).