Contents

Trading

Renewed hope?

New investor base in sight as UK government announces fresh measures

A series of measures announced by the UK government this week are being seen as a positive move for the structured finance market. Although immediate repercussions in the secondary market weren't apparent, traders believe that once details of the initiatives become clear primary issuance could make a return - with government guaranteed ABS potentially attracting a new investor base.

Three initiatives were put forward by the UK Treasury on Monday morning: a guarantee scheme for triple-A rated ABS backed by mortgages and consumer and corporate loans; an asset protection scheme; and an asset purchase facility, whereby the Bank of England will be authorised to buy £50bn of high quality structured finance assets (see News Round-up for more).

One ABS trader says that it is still unclear which collateral will be guaranteed by the government - mortgage and consumer loans that banks already have on their balance sheets, or newly-originated collateral specifically for the government guarantee scheme. "If mortgages are newly-originated for this purpose, the bonds will trade as different paper in comparison to traditional MBS - its pricing will be reflective of something between MBS and gilts, and will most likely attract a different investor base," he suggests.

Meanwhile, one structured credit investor expects the initiatives to stabilise spreads and support the ABS market in the long term, but in the short term he is concerned about potential oversupply. "The market may well become overcrowded in 2009, thanks to high volumes of government issuance competing with bank government-guaranteed issuance," he says.

However, lower origination of mortgages by UK banks in 2008 would mean there is less for banks to securitise and therefore would not necessarily lead to oversupply, the trader argues. According to the Council of Mortgage Lenders, lending was down 30% year-on-year in 2008.

The secondary MBS and ABS markets in general have seen a more positive tone this year compared to December, and so the announcements made by the UK government did not in themselves have a great impact on pricing or trading volumes on the day. Added to that is the fact that rumours of these implementations have been circulating for a while. "In general we have seen more investor interest since the beginning of the year, and investors with cash to put to work," comments another trader.

But securitisation research analysts at Deutsche Bank are not so positive about the government initiatives. "Although the UK government proposals may ease banks' funding challenges, provide additional stability to bond prices and see the creation of a government wrapped ABS market, it is no panacea," says Ivan Påhlson-Möller, research analyst at Deutsche Bank. "Even if banks get access to generous funding to originate affordable mortgages, they will be unlikely to offer high-LTV mortgages and, while borrowers may get access to cheap mortgages in terms of interest payments, the requirement of larger deposits will limit their ability to provide a strong bid for housing."

He adds: "The new schemes may thus limit the tail-risk of extreme asset price collapse, but we have little expectation of any rapid turn-around yet. The final effect is also very dependent on the precise form the measures take, something the government did not elaborate much on."

AC

Regulation

New regime

Basel 2 enhancements offer some positive potential

The Basel Committee on Banking Supervision's proposed enhancements to Basel 2 (see News Round-up) will make holding complex structured credit products more expensive. However, banks that upgrade their models accordingly should, in part, be able to mitigate such costs and gain some competitive advantage from doing so.

"Despite the fact that capital requirements in general will increase, those banks which understand the new rules better than their peers might actually benefit from the amendments in the long run," explains Martin Knocinski, regulatory and accounting specialist at UniCredit. For example, the Basel Committee does not provide any detailed guidance on how to calculate the newly introduced incremental risk charge (IRC).

Instead, Knocinski says: "The Committee provides some general parameters that banks have to consider when developing IRC models, which then have to be approved by the respective regulator. Sophisticated models might be expensive to develop; however, lower capital charges might be worth the effort."

The proposed changes to capital requirements cover: trading book exposures, including complex and illiquid credit products; certain complex securitisations in the banking book (such as ABS CDOs); and exposures to off-balance sheet vehicles (such as ABCP conduits). The new rules will make complex structured credit products more expensive from a regulatory capital perspective, but once implemented they should provide all parties with certainty about regulatory treatment. Knocinski suggests that such improved transparency might even help to overcome the current paralysis in structured credit.

"Given the Basel Committee's recent publications, it was foreseeable that the capital charges for resecuritisation would be increased significantly," he adds. "However, it is interesting to see that the Committee obviously still considers external ratings as an adequate means of measuring credit risk exposures, despite their sometimes questionable performance. In fact, at least for 'normal' securitisation exposures - i.e. non-resecuritsation exposures - risk weights have not been adjusted at all."

Not only is the Committee increasing capital requirements, but it is also seeking to improve the current regulatory framework by creating awareness of the importance of adequate risk management, oversight structures and due diligence. Knocinski says these efforts are positive, as they emphasise the fact that banks are ultimately responsible for the risks they take - whether these risks are adequately covered by current supervisory rules or not. "The fact that self-regulation has proved to be somewhat problematic in the past does not reduce such a statement's importance."

The Basel 2 framework is likened to a living organism that adapts to its changing environment in order to reach its objective. The new enhancements simply reflect the lessons that the financial industry and regulators have learned over the last 18 months - and they are unlikely to be the last.

One portfolio manager agrees: "Basel 2 has always had a long lead-in time, underscored by the fact that the Basel 1 floor will remain until 2010. By the time the new framework is fully implemented, it will have gone through several iterations. However, some underlying unease about a potential rollback remains."

While the portfolio manager recognises that structured credit and securitisation have long had problems with the Basel regulatory capital framework, he says that "ridiculous" suggestions about banks retaining percentages of everything they securitise don't help the process. "Any regulatory proposals should be subject to careful negotiation/discussion with industry participants and regulators should coordinate with each other because if the regime is too harsh, securitisers will move somewhere where it is friendlier."

There is no doubt that the new rules were absolutely necessary, according to Knocinski. When the financial crisis began, innovative products had already left the existing regulatory framework behind, as it didn't provide sufficient rules for them. Now regulators have made a significant step forward in order to keep up with industry structuring efforts.

He concludes: "Business opportunities have become less 'obvious' and structuring has become more difficult. However, as long as there are regulations, without a doubt there will also be regulatory arbitrage. That was the case with Basel 1; it is still the case with Basel 2 and will be the case with Basel 3. The question is not if, but when and to what extent."

CS

Alternative assets

Setting the standard

New Islamic issuance programme to take advantage of securitisation technology

The launch of a new Sharia-compliant issuance programme that uses securitisation technology is set to bring liquidity to the Islamic finance market and offer investors exposure to a broader range of assets than previously available. The issuing SPV - called Al Mi'yar Capital (from the Arabic "the Standard") - will issue Sharia-compliant tradable securities under the Luxembourg Securitisation Act of 2004.

"Al Mi'yar Capital, in simple terms, can be seen as a Sharia-compliant MTN issuance platform," explains Geert Bossuyt, md and regional head of Middle Eastern structuring at Deutsche Bank in Dubai, whose team arranged the programme. "The structure is flexible, meaning that other issuers will be able to plug into the platform. All documentation for the platform is freely available and it has been pre-approved by a number of Islamic scholars, so we invite the market to copy it. We believe it will bring a lot of value to Islamic markets and solve a lot of the problems that we have previously faced."

The certificates issued on the platform will be tradable Islamic securities, as they represent ownership in tangible Islamic assets. Those assets will be managed by Luxembourg Financial Group, an independent Islamic investment manager that generates returns - payable to the security holders - by selling those assets for a benchmarked sales price to an unrelated party.

Investors will receive a profit or loss on their investment based on the performance of the underlying reference assets or indices, which can include commodities, equities, funds or baskets. The choice of reference assets will depend on investor demand.

Allen & Overy capital markets partner, Andrew Sulston - whose team advised Deutsche Bank on the establishment of the programme - explains that the Luxembourg Securitisation Act of 2004 will provide for the ring-fencing of assets in relation to each issuance, giving it a compartmentalised structure.

In order to fund payments to investors, the issuer and a counterparty, such as Deutsche Bank, will enter into unilateral promises for the benefit of the other. Pursuant to one of the promises, the counterparty promises to purchase the Sharia-compliant assets from the issuer and, pursuant to the other, the issuer promises to sell the Sharia-compliant assets to the counterparty - each at the relevant settlement price (based on the independent reference asset or index). The promises are mutually exclusive.

The platform also provides for the issuance of tradable Islamic money market products settling with short settlement cycles (T+0), enabling the issuance of overnight products or other short-dated money market instruments. It is hoped that this facility will enhance the liquidity of Islamic money markets.

"Deutsche Bank has already used the platform to issue test paper to itself," says the bank's global head of Islamic finance Hussein Hassan. "We expect the first live issuance to take place within the next couple of weeks."

AC

CDPCs

CDPC run-off avoided by operating guideline change

Athilon has implemented an amendment to its operating guidelines that will extend the cure periods for its July and October suspension events, which were scheduled to end on 15 January and 28 April 2009 respectively, to match the end of the cure period for the CDPC's December suspension event due on 18 June 2009. On this date, Athilon will enter into a run-off period if any one of the suspension events remains uncured.

Moody's notes that the amendment doesn't have a credit impact due to the fact that, while a suspension event is continuing, Athilon may not enter into any new CDS transactions, voluntarily terminate any existing CDS transactions, or declare or pay any dividend distribution (other than in the form of equity securities). Consequently, the agency has confirmed that the counterparty and debt ratings currently assigned to Athilon will not, at this time, be reduced or withdrawn solely as a result of the implementation of the amendment.

Athilon breached its leverage ratio limit on 15 July 2008, which triggered a suspension event under its operating guidelines. In the absence of either curing the breached leverage ratio limit or executing the amendment, this would have resulted in the CDPC entering a period during which (i) the temporary trade cessation and certain operational restrictions imposed while a suspension event is continuing become permanent and (ii) a run-off of its existing transactions is required starting on 15 January 2009.

Meanwhile, on 28 October 2008 the CDPC breached both its overall expected loss and its expected loss per counterparty limits, which was primarily driven by the credit deterioration of certain ABS CDOs against which Athilon had written protection at the time of the failures (see SCI issue 96). Additionally, on 18 December 2008, Moody's downgraded the counterparty rating of Athilon to Baa1 on review for possible downgrade (the December suspension event).

CS

CLOs

Recovery fund closed

Further details of Intermediate Capital Managers' cash arbitrage CLO Recovery Finance Funding 2008 - via Lloyds TSB - have emerged, following the deal's close on 23 December. The transaction focuses on mispriced performing credit rather than distressed assets.

Rated by S&P, the deal comprises a £/€45m triple-A rated Class A1 revolver (which may be denominated in sterling or euros and is initially held by Lloyds) with a spread of 200bp over six-month Libor/Euribor, €155m triple-A rated Class A2 notes also with a spread of 200bp over and a €100m unrated subordinated tranche.

Net proceeds at closing were €229m, with €10m allocated to pay transaction fees and expenses due and the remainder to be invested in a portfolio of predominantly senior secured loans with a notional of at least €350m. On the effective date (11 August 2009) ICM will have the one-time-only possibility of selecting €350m, €365m, €385m, €410m or €435m as the target par amount for the deal.

Each target par amount has an associated break-even default rate matrix, which will be applicable during the life of the transaction. As a result, the available credit support for the class A1 and A2 notes on the effective date is expected to be between 42.86% and 54.02%.

The portfolio is expected to be purchased at an average price of between 60% and 75%. The manager is allowed to purchase discounted assets, but must limit assets with a current market value below 30% or below 20% under the portfolio average market value to 10% of the portfolio. All assets purchased below 80% of par are carried in the par-coverage test at their purchase price.

Recovery Finance Funding has a legal final of August 2018. The ramp-up period ends in July 2009, while the reinvestment period ends in February 2011.

CS

Correlation

Seven-notch downgrades likely as Moody's reviews CSOs

Moody's has revised and updated certain key assumptions that it uses to rate and monitor corporate synthetic CDOs. Structured credit practitioners report that the move is likely to have limited impact on the sector, however.

Based on initial assessment, Moody's expects to lower the ratings of a large majority of corporate synthetic CDO tranches by three to seven notches on average as a result of the review. The actual magnitude of the downgrades will depend on transaction-specific characteristics, such as tranche subordination, vintage and portfolio composition.

Moody's says it is revising its assumptions to reflect the expected stress of the global recession and tightened credit conditions on corporate default rates. Specifically, the changes announced today include:

• a 30% increase in the assumed likelihood of default for all corporate credits in synthetic CDOs;
• and an increase in the degree to which ratings are adjusted according to other credit indicators, such as rating reviews and outlooks.

The agency also announced an increase in the default correlation it applies to corporate portfolios as generated through a combination of higher default rates and an increase in investment grade and financial sector asset correlations. Asset correlation assumptions have been updated as follows:

• Increased inter-industry asset correlations of investment-grade corporate credits from 3% to as high as 8%.
• Reclassified corporate credits according to a new industry classification code.
• Merged four industries - banking, finance, insurance and real estate - into one.
• Increased the number of global industries from three to 12 and reduced the number of local industries from 15 to five.
• Increased intra-industry asset correlations.
• Portfolios with more than 8% concentration in a single industry are subject to an additive asset correlation penalty of up to 30%.

KBC is one bank that was quick to reassure the market about the impact of the move on its CDO holdings, given that its share price came under renewed pressure on the news. The bank says that the new model will only apply to three of the 17 CDOs that it has in portfolio (with a residual carrying value of approximately €200m), for which it had already proactively calculated the financial impact of a potential additional downgrade of three notches back in December. KBC added that, since Moody's will only be publishing its updated model later this month, it cannot currently simulate the extent to which this might adversely affect the bank's results.

Gregorios Venizelos, structured credit strategist at RBS, suggests that Moody's actions have "come too late to upset the CSO applecart from the rating perspective". This is not only because Fitch has already undertaken a similar exercise, but also because the loss of credibility in structured credit ratings has made investors more inure to such extensive downgrade actions.

Strictly rating-constrained investors (for example, investors who may have dropped Fitch and kept only Moody's rating on their tranche) may be forced into an unwind, but Venizelos believes that this is only a small part of the CSO universe (e.g. in the order of US$20bn of tranche notional versus a total of around USD$300bn). "The broad and deep damage to CSOs by the spate of financials defaults in September/October 2008 has already caused a major shakeout in the sector, not least in rating downgrades," he adds. "So it is a potential new spate of defaults - for example, in investment grade non-financial corporates - that we think will be the major threat to remaining CSO holdings in 2009/2010 and not further rating actions."

An area of more concern is arbitrage cashflow CLOs, where a similar methodology review is all but certain, according to Venizelos. "This does not bode well for CLOs, as with higher default probabilities and less industry categories we expect CLO diversity scores to fall (unless there are other mitigating changes to the methodology). This could put a downward rating pressure across the capital structure - albeit we need to see the details of the methodology changes before gauging the extent of potential downgrades."

Moody's is to immediately start reassessing all of its outstanding corporate synthetic CDO ratings across 900 transactions in the US, Europe and Asia using these updated assumptions.

AC & CS

Indices

Hedge fund index declines further

Both gross and net monthly returns for November 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index continued to slip into negative territory.

The latest figures for the index were published this week and show a gross return of -5.05% and a net return of -5.62% for the month of November (compared to -4.09% and -4.21% respectively in October). The moves mean that the gross and net indices show negative annualised returns since outset of -10.25% and -11.98%. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. It currently tracks 19 funds and represents over US$8bn of assets under management.

The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor. Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

CS

Operations

Repo collateral standards tightened

The Governing Council of the European Central Bank has ruled that, as of 1 March, ABS that is to be used as collateral for repo purposes must be rated triple-A. Further, ABS CDOs will not be accepted as eligible collateral after 1 March (although ABS resecuritisations issued before this date will be exempted until 1 March 2010). The ECB still requires only one rating to meet its eligibility, however.

The previous minimum rating for repo-eligible ABS was single-A minus. The objective of the changes is to contribute to the restoration of a proper functioning of the ABS market, the ECB states. It says that the current adjustments are aimed at fully preserving the key features of the Eurosystem's framework for credit operations, such as the wide-ranging eligibility of collateral and the broad access of counterparties to central bank liquidity, while maintaining an adequate level of risk protection for the system.

"The Eurosystem's collateral framework has proved to be robust and efficient over the years, also during the recent episode of financial market turbulence. In particular, the acceptance of a wide range of collateral contributes to the resilience of euro area financial markets," the ECB says.

Partially closing the ratings window should not have been unexpected, according to the ABS research team led by Ron Thompson at RBS. However, the analysts note: "We are confused by the willingness to allow ratings to drift to a single-A over the lifetime of the eligibility, as we would view a single-A rating that has not drifted at all as stronger than a rating that dropped to single-A. We have been hearing of pushbacks by the ECB around certain structural features in deals and certain jurisdictions, again not unexpected, but the ECB will need to wean issuers from dependence on its repo facility - and lower engagement likely will not come without pain."

AC

Investors

Transforming risk and return

Jochen Felsenheimer, co-head of credit at Assenagon, answers SCI's questions

Jochen Felsenheimer

Q: When did your company become involved in structured credit?
A: Assenagon just started to set up its credit business activities in January 2009 to provide institutional clients with asset and risk management solutions in the widespread area of credit, with the focus being clearly on credit derivatives and structured credit. The goal is to provide clients with a state-of-the-art risk management architecture based on systems and tools which are standard in investment banks rather than asset management companies. This architecture allows us to transform almost every risk and return profile of complex credit derivatives and structured credit instruments into a fund solution suitable for asset managers and insurance companies, as well as banks.

In addition, we serve our clients with transparent reporting on a daily basis. Our goal is to provide a broad range of clients with a framework which allows them to benefit from extremely attractive valuation levels embedded especially in complex credit instruments.

In its capacity as an asset management company Assenagon acts under Luxembourg supervisory and offers a high flexibility with respect to the legal set-up of the funds. The range of possible legal structures includes UCITS III part 1 and part 2 funds, as well as FCP and SICAV/F single investment funds.

The excellent infrastructure of Assenagon enables the unrestricted application of the full range of derivatives, including exotic derivatives. The observation of the 'Derivateverordnung' (German regulation for derivatives) is fully ensured at any point in time.

The Assenagon team has long-term experience in structured finance and derivatives solutions, including trading, risk management, reporting, regulatory issues and special fund solutions like ETFs.

Q: What, in your opinion, has been the most significant development in the credit market in recent years?
A: In the aftermath of the burst of the tech bubble in 2001/2002, the credit market was characterised by excessive risk taking, a dramatic increase in the volume of credit derivatives and by the ongoing development of highly complex structures to provide clients with an attractive return, even in a low yield environment. The high leverage in the market and embedded in many instruments just reflected the high appetite of clients to generate spread income in an environment of healthy economic growth, historical low default rates and strong technical demand for credit instruments.

The sale of CPDOs starting in August 2006 characterised the peak of risk taking in the credit space, when even credit derivatives rookies bought into highly leveraged instruments. The extreme undershooting of spreads on the back of the technical bid resulted in a historical low spread level in Q107.

At this time, the iTraxx Main broke through the 20bp threshold, just before the first signs of the sub-prime turmoil hit the market. The failure of two Bear Stearns hedge funds in June 2007 marked the turnaround of a healthy spread environment that had lasted for almost five years. I would call the period from June 2007 until now the ugly path into a new equilibrium, which will bring markets back to more realistic levels.

Q: How has this affected your business?
A: I think this is the perfect starting point for credit investments. On the one hand, many typical buyers of structured credits and credit derivatives will be out of the market for quite a while, especially banks. On the other hand, current market dislocations offer tremendous opportunities from a cyclical perspective.

Finally, new buyers will emerge, exploiting current market anomalies, while distressed structures will flood the market due to forced-selling. Providing new clients in the credit market with innovative solutions, accompanied by strategic portfolio advisory, seems to be the right answer to the current situation in credit markets.

Q: What are your key areas of focus today?
A: Although we see value especially in the distressed structured universe, even plain-vanilla credits provide investors with a decent spread income. Keep it simple, avoid highly-leveraged product, and provide transparent pricing and reporting - these are the major pillars of successful credit portfolio management. We will look at all credit assets, focusing on credit recovery and relative value opportunities.

Q: What is your strategy going forward?
A: Obviously, volatility will stay at elevated levels for several months and probably several quarters. For clients who can withstand some spread volatility, long credit exposure makes sense from a cyclical perspective. However, our focus is primarily on relative value opportunities, with the negative basis in many segments being the most obvious example.

We are able to provide clients with tailor-made solutions depending on their individual risk and return profile. Nevertheless, our recommendation is clearly to exploit current market anomalies while keeping directional risks limited.

Q: What major developments do you need/expect from the market in the future?
A: The most interesting aspect will be the answer of regulatory bodies to the sub-prime meltdown. Rising transparency and reducing counterparty risks - for example, by establishing clearing house solutions for credit derivatives - will be a major achievement in this process. This should certainly contribute to a rising popularity of credit derivatives and structured credit.

The risk is, however, that a kind of over-regulation will be implemented as a reaction to the crisis. In addition, the likelihood that governments will provide funding guarantees for non-banks on a broader scale could mean that spreads will gap in significantly from one day to another.

About Assenagon
Assenagon is a independent financial asset & risk manager in Europe, with a focus on structured investment solutions. Transparency and independence are the two essential attributes which differentiates the firm from competitors. These maxims are having a decisive relevance for its corporate culture.

Whereas most European asset managers are subsidiaries of big financial institutions, Assenagon is operating as partners of these institutions, independently, without a large back-office and highly efficiently. The fact that the firm can come to quick decisions and rapid implementation has arguably a positive bearing on the solutions it can offer; these advantages can be directly passed on to its customers. The long-term goal is to establish Assenagon as a leading independent asset and risk manager for structured solutions in Europe.

Structured credit advisory team launched

The latest company and people moves

Structured credit advisory team launched
Kensington Blake Capital has created a new financial services consulting firm formed around a team of structured products and derivatives professionals with backgrounds in structured finance, credit derivatives, interest rates and foreign exchange.

The partners include: Michael Bilello; Ricardo Diaz (most recently managing partner and founder of Angel Oak Capital Partners, a company investing in ABS, RMBS, CMBS and CDOs); Peter Dwyer (previously a director and structured trader on the corporate synthetic CDO desk at Wachovia); Sherif Elias (former director in the global rates business at Wachovia); Michael Hargadon (previously, coo of structured derivatives products); Kevin Kane (former director in Wachovia's structured products group); Bruce Lohman (previously at ABN AMRO, where he was an md in the global derivatives team in Chicago) and Brian Zwerner (former md and head of structured derivatives products at Wachovia). KBC was established in March 2008 as a financial consulting firm targeting opportunities in the structured finance and derivatives markets.

Distressed credit hedge fund to launch
Matrix Money Management has announced the launch of two new fund of hedge funds. The funds, which will be launching in February with a 1 March investment date, will be managed by the firm's in-house fund of hedge funds team, headed by Stuart Ratcliff.

Matrix Strategic Opportunities fund is being launched to capitalise on opportunities within credit markets, notably within distressed debt, high yield bonds, corporate loans and the restructuring process in bankruptcies. The fund will target a 15%-20% annualised return and has the flexibility to hold cash until the timing is right to invest in underlying hedge funds. The Matrix New Horizon fund will be a highly-diversified multi-strategy fund of funds looking to exploit the dislocations within the macro, credit and market-neutral environment.

Jeffries expands structured finance team
Jefferies & Co has added three to its ABS and MBS team. Beth Starr has joined as md. She was previously at Lehman Brothers, where most recently she was md in institutional sales.

Natasha Jacobs and Jason Eynon have been appointed svps. Jacobs joins from RBS Greenwich Capital and will work with Chander Gupta, who heads up ABS trading at Jeffries in London. Eynon joins from UBS, where he worked in institutional fixed income accounts.

CLO manager announces restructuring plans
Aladdin Capital has announced the first steps in its global restructuring plans for 2009. The firm is hoping to develop its advisory and investment banking businesses, together with its sales and trading and traditional asset management areas through key senior hires and an opportunistic acquisitions strategy. However, it will be reducing the headcount in its CLO and CDO businesses.

The implementation of the strategy is led by vice chairman and cio, Neal Neilinger, who joined the firm in October 2008 from Calyon (see SCI issue 110) with the mandate to steer Aladdin to best meet and capitalise upon the opportunities the new global financial landscape presents.

"Building out our advisory and investment banking businesses will position the firm to capitalise on growth opportunities globally going forward. We have hired key senior professionals to lead these businesses and our acquisitions strategy is in full swing," says Neilinger. "We expect to make some significant announcements in the near future."

Aladdin joins the growing number of firms that has turned to advisory services as a result of the financial crisis (see SCI issue 117, 'New Reality', for more).

DGAM adds md
Diversified Global Asset Management (DGAM), the hedge fund that invests in structured finance and distressed debt, has hired Todd Groome as an md. He will be responsible for business development, and will also advise the investment team on macro investment themes and the global economic and policy environment.

Most recently Groome was advisor, Monetary and Capital Markets Department, of the
IMF. Previously, Groome was head of the financial institutions groups of Deutsche Bank and Credit Suisse in London, focusing primarily on debt capital markets and capital and balance sheet management for banks and insurers. While at Deutsche Bank, he also managed the European high yield origination business for a period of time.

Opportunity funds fleshed out
Further details have emerged on the credit opportunities fund headed up by Deutsche Bank's ex-global head of credit and commodities, Rajeev Misra. The fund is understood to be called Clarent Capital Management and working with him will be four ex-colleagues from Deutsche Bank, including Antonio Di Flumeri, former global head of illiquid credit at Deutsche.

Meanwhile, Theo Constantinidis, former global head of fixed income, commodity and currency structuring at Merrill Lynch in London, has received regulatory approval for his credit opportunity fund, Panaxia Capital Management.

Mortgage firm hires ABS expert
Exact, a firm specialising in credit and collections within the mortgage arena, has hired Sebastien Maloney - an experienced mortgage trader, securitisation and risk manager - to the role of group finance director. He previously worked at Merrill Lynch as vp within the global structured finance & investments group. Prior to this, Maloney worked at GMAC as head of portfolio management & financial planning.

ABS and CDO businesses merged
RBS is understood to have merged its CDO business with its ABS desk in Asia, under the leadership of Byron Holmes, head of Asia-Pacific MBS and ABS. Chris Hodgeman, head of the Asian structured credit and alternatives business at RBS in Hong Kong, left the bank in December.

Law firm takes on CWT partners
The London office of Paul, Hastings, Janofsky & Walker has hired seven new partners from Cadwalader, Wickersham & Taft. Included in the new hires are partners that specialise in structured finance, investment funds and real estate finance.

Moving over are: Christian Parker, who focuses his practice on fund formation, including structured credit funds and similar investment structures, SIVs, restructuring through distressed workouts and general capital markets work; Charles Roberts, who focuses on CMBS, structured finance, loan syndication, commercial real estate finance and the restructuring aspects of those transactions in Europe and the US; and Conor Downey, who focuses on the financing and securitisation of mortgage loans.

Also joining Paul Hastings is Michelle Duncan, an international commercial litigation, restructuring, insolvency and regulation lawyer; Justin Jowitt, who focuses his practice on real estate finance work, including investment and development finance, restructuring of real estate loans and distressed real estate debt; Karl Clowry, who focuses on cross-border debt restructuring, distressed investments and corporate refinancing; and Tom O'Riordan, who focuses on all areas of international finance and banking.

CDO asset manager downgraded
Fitch has downgraded Société Générale Asset Management Alternative Investments (SGAM AI)' CDO Asset Manager rating to CAM2 from CAM2+. The downgrade primarily reflects the adverse impact that the credit crisis has had on SGAM AI's business franchise and the turnover at senior management level. It also takes into account Fitch's expectation of increased corporate and staffing instability stemming from the repositioning and restructuring of SGAM AI through its planned merger with Lyxor.

However, despite uncertainties over the exact scope and the effects of the consolidation with Lyxor, Fitch views positively the steps taken by management to restructure the franchise. Furthermore, the agency does not expect the CDO platform's core staff and processes to be materially affected on a day-to-day basis.

The rating continues to reflect SGAM AI's extensive alternative credit management experience with a core competence in IG corporate synthetic CDO management. The rating also reflects the company's expertise in financial engineering, which - combined with its recognised fundamental credit research capabilities - supports advanced risk management and trading practices. All these factors help SGAM AI to address current adverse market conditions in an appropriate manner, the agency notes.

Firm completes CDO exchanges
Reading International has consummated a series of CDO transactions that has resulted in a reduction of its debt. As part of the firm's efforts to reacquire up to US$22,925,000 of its preferred securities held by Kodiak CDO II, Reading has completed exchanges that have resulted in it reacquiring US$13,000,098 of these securities.

In two separate transactions that occurred on 14 and 15 January the CDO accepted securities proposed by Reading for this exchange at a 50% liquidation discount. That is, the firm purchased a total of US$6,500,049 worth of third-party securities and gave them to the CDO issuer, which simultaneously returned to the firm US$13,000,098 worth of its preferred securities.

As a result of these transactions, Reading expects to recognise a forgiveness of debt gain of US$6,500,049 in Q109.

Real estate securitisation pro hired
Doughty Hanson has strengthened its senior investment team with the appointment of Anders Tägt as a principal and head of its Nordic team. Tägt, who is based in the firm's Stockholm office, joins Doughty Hanson following seven years at Hypo Real Estate Bank, where he was a senior director in the bank's real estate structured finance and investment banking division and was responsible for a loan book of more than €3.5bn.

As a principal and head of the Nordic Region, Tägt will help to develop Doughty Hanson's overall investment strategy in the Nordic Region and will originate and lead transactions in these markets.

Doughty Hanson is currently investing its second Fund, Doughty Hanson & Co European Real Estate Fund II, which closed in 2006 with commitments of €590m. Fund II has completed eleven investments to date, representing about 60% of the Fund.

Law firms adds to structured finance team
Schulte Roth & Zabel has hired David Karp as a special counsel in the business reorganisation group. Karp focuses his practice on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and bankruptcy aspects of structured finance.

Distressed opportunities director hired
The Carlyle Group has appointed Ian Jackson, a senior analyst with Deutsche Bank's European distressed products group in London, as director of Carlyle Strategic Partners - the group's distressed and corporate opportunities arm. Before his analyst role, Jackson spent five years working for Deutsche Bank's Japanese distressed products group in Tokyo, acquiring non-performing loan portfolios and trading Yen-denominated corporate bonds into US/European clients.

BofA gets Treasury protection
The US Treasury and the Federal Deposit Insurance Corporation is to provide protection to another bank - Bank of America - against the possibility of unusually large losses on an asset pool of approximately US$118bn of loans, securities backed by residential and commercial real estate loans and other assets - all of which have been marked to current market value. The large majority of these assets was assumed by Bank of America as a result of its acquisition of Merrill Lynch and will remain on Bank of America's balance sheet.

The ring-fenced securities comprise US$37bn of cash assets and US$81bn of derivatives, with the guarantee lasting for 10 years for residential assets and five years for non-residential assets. BofA will take the US$10bn first loss layer, the government will take a US$10bn second loss layer and losses on top of that will be shared 90% government/10% BofA. BofA can draw on the Fed loan facility if actual and mark-to-market losses top US$18bn, with undrawn amounts being charged at a 20bp fee and drawn amounts at 300bp over OIS.

As a fee for this arrangement, Bank of America will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan. The Treasury will also invest US$20bn of TARP funds in Bank of America in exchange for preferred stock.

Bank of America will comply with enhanced executive compensation restrictions and implement a mortgage loan modification programme.

The Treasury exercised this funding authority under the Emergency Economic Stabilization Act's Troubled Asset Relief Programme (TARP). Separately, the FDIC board announced that it will soon propose rule changes to its Temporary Liquidity Guarantee Program to extend the maturity of the guarantee from three to up to 10 years, where the debt is supported by collateral and the issuance supports new consumer lending.

With these transactions, the Treasury says it is taking the actions necessary to strengthen the financial system and protect US taxpayers and the US economy.

Permacap declares dividend
Carador has declared an interim dividend of €0.0015 per ordinary share in respect of the quarterly period ended 31 December 2008, payable on 30 January 2009. This is the first quarterly dividend payable by the company and the first dividend following its amalgamation with Abingdon Investment on 9 December 2008.

AC & CS

UK bank bailout 'Mark 2' launched

A round-up of this week's structured credit news

UK bank bailout 'Mark 2' launched
Three initiatives were put forward by the UK Treasury on Monday to bolster financial markets: a guarantee scheme for triple-A rated ABS backed by mortgages and consumer and corporate loans; an asset protection scheme; and an asset purchase facility, whereby the Bank of England will be authorised to buy £50bn of high quality structured finance assets. The measures are expected to prove positive for the ABS market through the resumption of primary issuance (see separate News Analysis story).

The Government Asset Protection Scheme is designed to protect UK financial institutions against exposure to exceptional future credit losses on certain portfolios of assets, including structured credit and ABS product. More specifically the scheme will provide - to eligible institutions - protection for portfolios containing: commercial and residential property loans most affected by current economic conditions; structured credit assets, including certain ABS; certain other corporate and leveraged loans; and any closely related hedges, in each case, held by the participating institution or an affiliate as at 31 December 2008. Assets may be denominated in any currency.

Under the scheme the Treasury will, in return for a fee, provide to each participating institution protection against future credit losses on one or more portfolios of defined assets to the extent that credit losses exceed a first loss amount to be borne by the institution. Such protection will cover the major part, but not all, of the credit losses which exceed this first loss amount.

Each participating institution will be required to retain a further residual exposure, which is expected to be in the region of 10% of the credit losses which exceed the first loss amount. This residual exposure will provide an appropriate incentive for participating institutions to keep losses to a minimum, the Treasury says.

Eligible institutions will, in the first instance, include UK incorporated authorised deposit-takers (including UK subsidiaries of foreign institutions) with more than £25bn of eligible assets. Affiliated entities will also be considered by the Treasury for protection under the scheme in the light of its assessment of the impact on financial market stability and the overall economy. The scheme may also in time be extended more widely to other UK incorporated authorised deposit-takers.

Assets covered by the scheme will continue to be managed by the institution and will remain on its balance sheet, but will be required to be 'ring-fenced' by the institution so that actions in relation to them - including enforcement and disposal - will be subject to appropriate Treasury controls. The initiative may also provide for the Treasury to take over ownership and/or management of the assets in certain defined circumstances. Participants in the scheme will be subject to a verifiable commitment to support lending to creditworthy borrowers in a commercial manner.

Meanwhile, the government's new guarantee scheme for ABS draws on the recommendations of Sir James Crosby (see SCI issue 114) to improve banks' access to wholesale funding markets, help support lending and promote robust and sustainable markets over the longer term. The government will, in consultation with issuers and investors, provide full or partial guarantees to be attached to eligible triple-A rated ABS, including mortgages and corporate and consumer debt.

UK banks and building societies eligible to participate in the CGS will be able to access the new scheme, subject to fulfilling certain conditions. Banks and building societies accessing the scheme will follow international standards and best practice on underwriting, disclosure, reporting and valuation.

The government will set conforming criteria to ensure that only transparent structures and high quality assets are eligible. The scheme will commence in April 2009, subject to state aid approval.

As a further step to increase the availability of corporate credit, by reducing the illiquidity of the underlying instruments, the Bank of England will set up an asset purchase programme implemented through a specially created fund. The BoE will be authorised by the Treasury to purchase high quality private sector assets, including paper issued under the CGS, corporate bonds, commercial paper, syndicated loans and a limited range of ABS created in viable securitisation structures.

The Treasury will authorise initial purchases of up to £50bn, financed by the issue of Treasury bills. Given the scale of the programme, the Bank will be indemnified by the Treasury.

This programme will come into effect from 2 February and also provides a framework for the Monetary Policy Committee (MPC) of the Bank of England to use asset purchases for monetary policy purposes, should the MPC conclude that this would be a useful additional tool for meeting the inflation target. In such circumstances, the scale of the scheme could be expanded, with a further announcement being made.

Valuation service launched
S&P has launched Valuation Scenario Services for Structured Asset Portfolios, a new service to help investors evaluate the intrinsic value of structured assets and complex securities. The new service is provided by S&P's Fixed Income Risk Management Services (FIRMS) business, which offers a range of analytics that give investors greater context around asset pricing and the detailed relationships between counterparties and obligors. FIRMS is already working with a number of central banks, regulatory and industry bodies, as well as investors, to help them value complex and illiquid securities.

With an estimated US$4trn in structured assets held in investor portfolios, the ability to conduct systemic valuation analyses that are well-defined and methodologically consistent across all assets fulfills a critical need in the current market, S&P says. The analytics provided by Valuation Scenario Services offer investors a step-by-step, transparent assessment of their structured portfolios under a range of different assumptions and economic scenarios. This information is then reviewed in a collaborative decision support process with clients to help drive an improved understanding of structured credit portfolio value.

"Market uncertainty, a lack of liquidity and an overall crisis sentiment are combining to create a disrupted relationship between market-observed pricing and the intrinsic value of structured assets on investors' balance sheets," explains Lou Eccleston, executive md of FIRMS. "Our Valuation Scenario Services help investors analyse their portfolios against a multitude of potential economic scenarios to get a much clearer picture of the real value of the paper they are holding."

The new offering is supported by S&P's market, credit and risk strategies team (a newly formed, independent research group that analyses cross-market and cross-asset class valuations and relationships); its structured finance platform and modeling team; and its fixed income architects team.

Basel 2 capital framework enhanced
The Basel Committee on Banking Supervision has issued a package of consultative documents designed to enhance the Basel 2 capital framework, as part of a broader effort to strengthen the regulation and supervision of internationally active banks in light of weaknesses revealed by the financial markets crisis (see also separate News Analysis story). The proposed changes to capital requirements cover: trading book exposures, including complex and illiquid credit products; certain complex securitisations in the banking book (such as ABS CDOs); and exposures to off-balance sheet vehicles (such as ABCP conduits).

The Committee is also proposing standards to promote more rigorous supervision and risk management of risk concentrations, off-balance sheet exposures, securitisations and related reputation risks. Through the supervisory review process, it is promoting improvements to valuations of financial instruments, the management of funding liquidity risks and firm-wide stress testing practices.

In addition, the Committee is proposing enhanced disclosure requirements for securitisations and sponsorship of off-balance sheet vehicles, which should provide market participants with a better understanding of an institution's overall risk profile. The aim is for capital requirements for the trading book to be implemented in December 2010, while the other improvements - including those related to risk management and disclosures - should be introduced by the end of 2009.

According to Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank: "The proposed enhancements will help ensure that the risks inherent in banks' portfolios related to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public."

The proposals would see the current value-at-risk-based trading book framework being supplemented with an incremental risk capital charge (IRC), which includes default risk as well as migration risk, for unsecuritised credit products. For securitised products, the capital charges of the banking book would apply. Once implemented, the IRC will reduce the incentive for regulatory arbitrage between the banking and trading books, the Committee says.

An additional proposed response is the introduction of a stressed value-at-risk (VaR) requirement. Losses in banks' trading books during the financial crisis have been significantly higher than the minimum capital requirements under the Pillar 1 market risk rules.

Banks will therefore now be required to calculate a stressed VaR, taking into account a one-year observation period relating to significant losses, which would be in addition to the VaR based on the most recent one-year observation period. The additional stressed VaR requirement will help reduce the pro-cyclicality of the minimum capital requirements for market risk, the Committee notes.

Finally, it proposes to discontinue the preferential treatment of a 4% capital charge for specific risk of equities that is currently applicable to portfolios that are both liquid and well-diversified. As a result, an 8% capital charge for specific risk of equities would apply in all cases. In addition, the Committee will be initiating a longer-term, fundamental review of the risk-based capital framework for trading activities.

Wellink adds: "The Committee intends to coordinate and implement this work programme in a manner that strengthens financial confidence and avoids aggravating current market conditions. It will not increase required global minimum capital ratios during periods of economic and financial stress. The Committee notes that adequate capital buffers above the regulatory minimum are designed to absorb losses and support continued lending to the economy."

In addition to the IRC and other trading book proposals, the Committee is proposing other Pillar 1 (minimum capital requirements) enhancements that focus on strengthening the risk capture of the framework. The crisis has clearly shown that ABS CDOs are more highly correlated with systematic risk than traditional securitisations, for example. Resecuritisations, therefore, warrant a higher capital charge.

Equally, prior to the onset of the financial crisis banks built up significant exposures to off-balance sheet conduits that were not adequately reflected in the capital regime. In response, the Committee proposes to increase capital requirements for liquidity lines extended to support ABCP conduits by eliminating the distinction between short-term and long-term liquidity facilities.

The Committee also proposes requiring that banks obtain comprehensive information about the underlying exposure characteristics of their externally-rated securitisation positions, both within and across structures. Failure to obtain such information would result in higher capital requirements.

Meanwhile, supplemental Pillar 2 (supervisory review process) guidance addresses the flaws in risk management practices revealed by the crisis, which the Committee recognises in many cases as symptoms of more fundamental shortcomings in governance structures at financial institutions. It sets clear expectations for boards of directors and senior management to understand the firm-wide risk profile; to aggregate firm-wide exposure information in a timely manner using easy to understand and multiple metrics; to define the risk appetite in a manner that considers long-term performance over the cycle; and to set clear incentives across the firm to control risk exposures and concentrations in accordance with the stated risk appetite.

Finally, after a careful assessment of leading disclosure practices, the Committee has developed proposed revisions to the existing Pillar 3 (market discipline) requirements, focusing on the following six areas:

• securitisation exposures in the trading book;
• sponsorship of off-balance sheet vehicles;
• the Internal Assessment Approach (IAA) for securitisations and other ABCP liquidity facilities;
• resecuritisation exposures;
• valuation with regard to securitisation exposures; and
• pipeline and warehousing risks with regard to securitisation exposures.

These disclosures are intended to complement the other two pillars of the Basel 2 framework by allowing market participants to assess capital adequacy of a bank through key pieces of information on the scope of application, capital, risk exposure and risk assessment process. The Committee believes that these proposed enhanced disclosure requirements will help to avoid a recurrence of market uncertainties about the strength of banks' balance sheets related to their securitisation activities.

Auction called for Nortel Networks ...
ISDA is to launch a CDS auction protocol to facilitate the settlement of credit derivatives trades referencing Nortel Networks Corp, the Toronto-based telecom giant. Nortel Networks announced that it will seek creditor protection under the Companies' Creditors Arrangement Act (CCAA) in Canada, along with Nortel Networks Ltd and certain of its other Canadian subsidiaries.

... while Ecuador price is determined
Markit and Creditex, in partnership with major credit derivative dealers, have announced the results of the credit event auction conducted to facilitate settlement of credit derivative trades referencing Ecuador debt. This marks the first time that an auction has been run to CDS referencing the debt of a sovereign nation or an emerging market credit.

The final price of Ecuador bonds was determined to be 31.375% for the purpose of settling credit derivative transactions. Market participants who bought protection against an Ecuador default will therefore receive the face value of their bonds in exchange for a payment of 31.375% of face value to protection sellers.

Speculative grade default rates to reach 15.1%
Global speculative grade default rates have increased more than fourfold in 2008, from 0.9% to 4.0%, according to Moody's. The number of companies rated by the agency that defaulted in 2008 was 104 - 86 of which were in North America and 12 in Europe - up from only 18 in the whole of 2007. Looking ahead, the agency expects global speculative grade default rate to rise to 15.1% in its base-case scenario.

Default rates are likely to significantly exceed the peaks of 1991 and 2002 when they reached 11.9% and 10.4% respectively. The reason for this, according to the agency, is that economic conditions are already substantially weaker than in the past two credit cycles. The benchmark will then become the peak default rates reached during the Great Depression, when they hit 15.4%.

Moody's view is that Europe will fare worse than the US in the downturn in terms of defaults. The geographical breakdown of its baseline forecasts reveals that US defaults could peak at 15.8%, while European defaults could rise as high as 18.3%.

Credit analysts at BNP Paribas note that these predictions do not bode well for credit. However, they point out that valuations already reflect very extreme scenarios.

Moody's worst-case prediction on five-year cumulative defaults for European speculative-grade credits is 35.8%. By comparison, the iTraxx Crossover at 1000bp compensates investors for default rates up to 40.7% at 0% recovery, and 48.0% at 20% recovery. For cash bonds valuations are even more attractive, largely due to a sizeable liquidity premium built into the spreads (which BNP Paribas estimates to be about 100bp-150bp).

G30 reports on financial stability
The G30 has released a report entitled 'Financial Reform: A Framework for Financial Stability,' which it says is intended to help inform the needed debate among policymakers and the international financial community on regulatory issues. The report has caused some controversy over its stance on structured credit and securitised products.

The report addresses: policy issues related to redefining the scope and boundaries of prudential regulation; reforming the structure of prudential regulation; improving governance, risk management, regulatory policies and accounting practices and standards; and improvements in transparency and financial infrastructure arrangements. "Extensive innovation in the capital markets and the rapid growth of securitisation make it imperative that securitised and other structured product and derivatives markets be held to regulatory, disclosure and transparency standards at least comparable to those that have historically been applied to the public securities markets," the report states. "This may require that a broader range of markets be monitored, that there be adequate transparency as to transaction volumes and holdings across all products, and that both credit and leverage elements of each product be thoroughly understood and monitored."

The report notes that the healthy redevelopment of securitised credit markets requires a restoration of market confidence in the adequacy and sustainability of credit underwriting standards. To help achieve this, regulators should require regulated financial institutions to retain a meaningful portion of the credit risk they are packaging into securitised and other structured credit products, according to the G30.

Furthermore, the disclosure and dissemination regime for asset-backed and other structured fixed income financial products in the public and private markets should be enhanced. The G30 recommends that the appropriate national regulator should, in conjunction with investors, determine what information is material to investors in these products and should consider enhancing existing rules or adopt new rules that ensure disclosure of that information, for both asset-backed and synthetic structured products. The appropriate national regulator should condition transactions in the private and wholesale markets on satisfaction of appropriate information disclosure standards.

"Efforts to restore investor confidence in the workings of these markets suggest a need to revisit evaluations of the costs and benefits of infrastructure investments that would facilitate a much higher level of transparency around activity levels, traded prices and related valuations," the report says. "Part of the costs of such changes is the impact on firm-specific concerns regarding the private nature of their market activity. These concerns, and direct investment costs, need to be weighed against the potential benefits of higher levels of market transparency."

Regulatory policies with regard to NRSROs and the use of ratings should also be revised, preferably on an internationally coordinated basis, to achieve the following: users of risk ratings, most importantly regulated users, should be encouraged to restore or acquire the capacity for independent evaluations of the risk of credit products in which they are investing; risk ratings issued by the NRSROs should be made more robust, to reflect the risk of potential valuation losses arising not just from default probabilities and loss in the event of default, but also from the full range of potential risk factors; and regulators should encourage the development of payment models that improve the alignment of incentives among the providers of risk ratings and their clients and users, and permit users to hold NRSROs accountable for the quality of their work product.

Meanwhile, the G30 notes that much-needed planned improvements to the infrastructure supporting the OTC derivatives markets should be further supported by legislation to establish a formal system of regulation and oversight. Given the global nature of the market, it is essential that there be a consistent regulatory framework on an international scale, and national regulators should share information and enter into appropriate cooperative arrangements with authorities of other countries responsible for overseeing activities.

DTCC expands public CDS data
The DTCC is expanding the data its Deriv/SERV unit publishes on CDS registered in its Trade Information Warehouse to show additional detail on weekly transaction activity, such as new trades, terminations and assignments in terms of gross notional values, as well as number of contracts. From 20 January, the contract data posted on DTCC's website will include a new section - Section III - providing data in the aggregate, as well as for single name reference entity sectors and for major indices.

DTCC began posting gross and net notional values and numbers of contracts for single name reference entity sectors, indices and tranches on 4 November 2008. Section I shows the outstanding notional values and contract numbers at a given point in time (the end of each week). Supporting documentation that explains the data being published will also be posted on the website in conjunction with the release of the new data.

"By publishing CDS contract data each week from its Trade Information Warehouse, DTCC is delivering critical transparency to the credit default swaps market," comments Frank De Maria, DTCC md and DTCC Deriv/SERV coo. "Users of the Warehouse, market analysts, journalists and regulators have found our data tables to be an invaluable resource in providing a global view of weekly market activity."

Capitalising on credit volatility
After analysing fundamental and technical drivers of credit spreads for 2009, quantitative credit strategists at Barclays Capital recommend selling/buying protection outside of the following ranges: for iTraxx Main, sell protection at 250bp and buy protection at 150bp; for iTraxx Crossover, sell protection at 1100bp and buy protection at 750bp.

By selling strangles struck at these ranges, the investor can get paid a significant premium today to commit to buying or selling protection at these spread levels at expiry if the prevailing spread is outside that range, the strategists note. Additionally, due to the high intraday volatility and strong momentum in spreads, credit volatility is rich; the proposed trade format exploits this richness to implement longer-term strategic credit views.

Counterparty risk increases again
Counterparty risk rose the most last week since 20 November, according to Credit Derivatives Research, removing all of the pre-holiday improvements as a slew of idiosyncratic events hit the major US and European financial institutions. The CDR Counterparty Risk Index (CRI) rose over 40bp to 188bp (around 22% riskier) as US banks underperformed Europeans during a tough week.

Citigroup was the worst performer of the CRI members as its risk rose over 85% to 365bp (peaking at over 400bp). Concerns over the desperation of the Morgan Stanley deal, combined with break-up talk, brought CDS succession issues to the forefront as the good-bank/bad-bank model was discounted in current spreads. Credit Suisse was the only CRI member tighter on the week, eking out a 2bp rally (while its stock is down 17%), with Deutsche Bank and UBS the other better performers.

CDR's thematic view for 2009 remains that government support will keep credit spreads from blowing out among these systemically important financial institutions, while capital injections will dilute common stock. A strategy of selectively shorting stock against long credit positions seems prudent, the analysts suggest, especially given that the request for the US$350bn second tranche of TARP has been granted.

Second monthly fall for CRE CDO delinquencies
US commercial real estate loan (CREL) CDO delinquencies declined to 2.72% for December 2008, down slightly from 2.8% in November 2008, according to the latest update from Fitch. While seven loans were added to the CREL DI, the extension of two large performing matured balloon loans led to the overall decrease of 8bp. Of the newly delinquent loans, three were term related delinquencies, one was a repurchase and three were maturity defaults.

"Although the CREL DI decreased for the second straight month, this trend is not expected to continue," says Fitch senior director Karen Trebach. "As real estate fundamentals continue to weaken under the deepening recessionary conditions and capital markets remain constrained for new commercial real estate lending, a rise in the delinquencies over the next few months is likely."

Asset managers continue to extend loans, with 22 new loan extensions reported this past month compared to 45 in November. Approximately 60% of these extensions were options contemplated in the original loan documents.

While repurchases have been rare in recent months, one asset (1bp) was repurchased in December. This mezzanine loan interest was secured by an interest in an office property 100% leased to a recently bankrupt retail operator. The asset manager purchased the loan out of the CDO at par.

Asset managers also continue to exercise their rights to trade credit risk assets out of CDOs at discounts to par. In general, they have used the proceeds from these trades to acquire higher rated assets, also at a discount, taking advantage of current market conditions.

Nearly 36% of the loans in the CREL DI are collateralised by multifamily properties. Going forward, however, Fitch anticipates that loans backed by hotel and retail properties will become more pronounced in the index.

Clarification for embedded credit derivatives accounting ...
FASB has issued Proposed Statement 133 Implementation Issue C22, 'Exception Related to Embedded Credit Derivatives'. This proposed Implementation Issue is designed to amend the accounting and reporting requirements of paragraph 14B of Statement 133 to provide clarifying language to Statement 133 regarding when embedded credit derivative features - including those in CDOs and synthetic CDOs - are not considered embedded derivatives subject to potential bifurcation and separate accounting.

The proposed Implementation Issue addresses the scope exception for embedded credit derivative features related to the concentration of credit risk in the form of subordination of one financial instrument to another. "The objective of this proposed Implementation Issue is to improve financial reporting by resolving some potential ambiguity about the breadth of the embedded credit derivative scope exception in paragraph 14B," according to FASB.

...while SFAS 155 changes could result in CSO exodus
Proposals from FASB to amend SFAS 155 - under which accrual accounting for synthetic CDO-linked notes would be eliminated - could lead to investors that are wary of earnings volatility exiting their transactions, according to structured credit research analysts at Barclays Capital.

Investments, such as an exposure to a synthetic CDO swap embedded in a credit-linked note, can currently be accounted for as a single instrument under SFAS 155. But under the new proposals, the CDO contract will have to be split into its collateral and the unfunded synthetic CDO swap. Separate accounting for the two components will likely result in earnings volatility.

"Given the distressed levels prevalent today (often below US$20), the volatility is asymmetric toward the positive side and may prevent an immediate mass exodus," say the BarCap analysts. "However, when markets rally, investors may have the incentive to unwind their positions, thus dampening the rally itself. As a result of this technical and the continued deterioration in credit quality, we believe that the junior mezzanine part of the capital structure will remain under pressure."

CDO/CDS-related REITs and REOCs reclassified
S&P has reclassified the real estate investment trusts (REITs) and real estate operating companies (REOCs) that issue debt securities owned or referenced by the CDOs and CDS that it rates. The agency's commercial real estate and structured finance CDO groups worked together to develop these revised assumptions after they evaluated the characteristics and expected performance of the institutions operating in the real estate industry. These changes, which affect CDOs and CDS globally, reflect its views on the expected behaviour of the different real estate sectors.

S&P has created two subcategories - mortgage REITs and equity REITs/REOCs - and reclassified each entity appropriately. Under these subcategories, mortgage REITs are generally defined as REITs that focus primarily on real estate financing, and equity REITS are generally defined as REITS that invest mainly in real estate equity.

The agency says it has reclassified these entities exclusively for the purposes of running CDO Evaluator. Furthermore, it may modify this list periodically to refine its view of the classification of any particular entity when running CDO Evaluator, to delete entities currently in the list that may be merged or ceased to exist, and/or to add entities that may not currently be included in the list as they become part of a CDO or CDS that it rates.

Liz Claiborne Mod-R clause to trigger?
Speculation continues about whether amendments to Liz Claiborne's revolver facility have triggered single name CDS. While the modified-restructuring clause won't impact indices or standardised tranches, it is of critical importance to single name CDS and bespoke CDO deals.

Uncertainty arises from two issues, according to analysts at Credit Derivatives Research - whether at least two-thirds have consented to the amended terms and, more importantly, whether it resulted directly or indirectly from a deterioration in creditworthiness. The Mod-R requirements that are satisfied in CDR's view are the extension of maturity, reduction of par amount, partially-drawn revolver, amendment of existing facility (rather than pay-down and re-borrow) and finally that the facility be held by at least four unaffiliated groups.

"Certainly, if this indeed is a trigger, then there may be a slew of further CDS triggers as many firms are doing a similar thing with their facilities. The impact of the idiosyncratic event for LIZ and systemic event for other facility changes may have significant impacts on bespoke CDOs and implicitly into the standardised indices," the analysts note.

CDR sees only limited downside in the on-the-run CDS. Given that its view of equity-implied default risk is high, its MFCI model's view on the expected risk is considerably higher and the macro view of a long and deep recession driven by ever-falling consumer-spending, the analysts note that it appears that the downside from a short-term higher recovery driven by a bond squeeze may be worth taking for a much lower recovery rate via Chapter 11 later in the year.

Ratings lowered/withdrawn on Lehman CSOs
S&P has lowered to single-D or withdrawn its ratings on Lehman Brothers-backed synthetic CDOs. Some 31 tranches from 18 CSO transactions have been downgraded to single-D, while ratings have been withdrawn on 63 tranches from 19 CSOs.

The agency has withdrawn ratings on the tranches that received their principal and interest due in full after the early termination of the notes, triggered by an indenture event of default following Lehman's bankruptcy filing. The tranches downgraded to single-D are those that experienced interest shortfalls because they relied on Lehman to make up the spread component of the interest due. The interest shortfall caused the transactions to dip into principal cash to pay the interest shortfalls, which led to ultimate principal losses on the notes.

European ABCP issuance lags the US
In the latest edition of its 'European ABCP Paper Trail', Fitch notes that the volume of European ABCP issuance lags that of the US ABCP market. In its market update, the agency attributes this mainly to the effect of the Commercial Paper Funding Facility (CPFF) implemented by the US Federal Reserve in a bid to create liquidity in the sector. Focusing on the European market, the newsletter provides a snapshot of recent events and how conduits are responding to the ongoing market upheaval.

Another article entitled, 'On or Off? ABCP Conduits and Basel II', comments on a special report issued by the agency surrounding the impact of the new Basel II capital requirements on the ABCP universe - one of the most affected segments of the structured finance market. Furthermore, the newsletter provides updated information on the latest outstanding CP and underlying asset pool composition.

2009 to present "greatest pressure" on European securitisation
The year ahead is likely to present the greatest pressure on European structured finance collateral performance since the market's inception, according to S&P's outlook report for 2009. The agency expects collateral deterioration to contribute more strongly to negative rating actions and believes that higher rated tranches remain better protected from default, given their greater levels of credit support. However, downgrades could occur wherever it is considered that credit risk is materially increasing.

S&P believes that European CDOs remain exposed to deterioration among global corporate credits, but as and when any corporate entities experience difficulties the scale of any CDO rating effect will strongly depend on how widely referenced they are.

"Broad economic deterioration could lead to higher corporate insolvencies and unemployment, and, in some cases, continued deterioration in underlying asset values," says S&P surveillance credit analyst Andrew South.

"This will likely lead to higher losses in collateral pools," he adds. "In commercial and some areas of residential mortgage lending, we believe there has been a long-term shift in the landscape of credit provision, and that this will have further negative implications."

The situation contrasts with that in 2008, when affordability issues were initially a key driver of weaker performance. In the RMBS asset class, for example, rising mortgage rates in some countries placed a greater burden on borrowers, who also had fewer options to refinance out of trouble, given the contraction in credit offerings.

According to South: "We believe that affordability pressures could ease this year, given central bank rate cuts and other forms of government intervention across the globe. However, we do not expect these positive developments to arrest the deterioration in collateral performance in all cases, as economic activity in many jurisdictions has slowed sharply."

In consumer asset classes, Spain, the UK and Ireland are most exposed, in S&P's view, due to weaker prospects for economic growth and employment. The agency considers that borrower performance in other European countries is less at risk, given more conservative household balance sheets and/or a less pronounced prior bubble in property prices.

"Last year certain downgrades resulted from issues relating to financial counterparties providing support to transactions, rather than fundamental concerns over collateral performance. Although such counterparty-related problems cannot be ruled out in 2009, we expect collateral performance deterioration to contribute more strongly to negative rating actions," continues South.

In the year ahead counterparty problems could weaken ratings in the senior part of a securitisation's capital structure if the counterparty is not replaced. However, S&P expects that collateral deterioration in 2009 is most likely to damage lower-rated notes. It believes that senior notes could remain less affected because improvements in transaction structures over time can partially compensate for collateral deterioration over the same period.

Japanese CDOs on review
S&P has placed its ratings on 33 tranches relating to 26 Japanese synthetic CDO transactions on credit watch with negative implications. At the same time, the agency affirmed its ratings on 23 tranches relating to 18 deals and removed the ratings from credit watch with negative implications. A further five tranches relating to five transactions were also placed on credit watch with positive implications.

The 33 tranches that were placed on watch negative had SROC levels that fell below 100% during S&P's monthly review on 6 January. Meanwhile, the 28 tranches whose ratings were either affirmed or placed on watch positive had SROC levels that recovered to 100% or above.

The monthly review was rescheduled to 6 January from the end of December to allow time for the data to reflect the auction results of ISDA's protocol for Tribune.

Negative outlook for EMEA ABS/RMBS
The performance outlooks for EMEA ABS and RMBS are negative, says Moody's in its 'Review 2008 & Outlook 2009' report about the two asset classes.

"The deterioration of economic conditions does not bode well for the performance of underlying assets in most structured transactions, hence the negative outlook for most asset sectors across ABS and RMBS (with the outlook horizon defined as 12-18 months)," says Nitesh Shah, an economist at Moody's.

However, the agency adds that the rating implications for most asset categories remain limited at this stage because performance is not expected to deteriorate significantly beyond what has been assumed in the ratings for most asset sectors.

Citi SIVs on downgrade review ...
Moody's has placed the Aa3 ratings of six Citibank-sponsored SIVs on review for downgrade. The affected vehicles are Beta Finance Corp, Centauri Corp, Dorada Corp, Five Finance Corp, Sedna Finance Corp and Zela Finance Corp.

The rating actions affect twelve MTN programmes with total debt outstanding of US$13.2bn. The Prime-1 ratings of all six vehicles were affirmed.

The rating actions follow Moody's decision to place Citibank's long-term rating of Aa3 on review for downgrade and to affirm the Prime-1 short-term rating. The direct linkage between the senior debt ratings of the vehicles and those of Citibank is based on a forward transfer agreement between Citibank and each of the affected vehicles executed on 18 November 2008. Under the agreement, Citibank agreed to purchase the assets of each vehicle in return for the provision of liquidity to the SIV, so that it can fully repay all its senior liabilities as they fall due.

... while Victoria's ratings are withdrawn
Moody's has withdrawn the capital note and senior debt programme ratings of Victoria Finance, a SIV established by Ceres Capital Partners. Management of the vehicle was transferred to the collateral agent, Deutsche Bank Trust Company Americas, when it entered enforcement on 8 January 2008. The rating action follows a request by the collateral agent.

Given that all management responsibilities now rest with the collateral agent, Moody's has also withdrawn the SIV management quality rating that was assigned to Ceres Capital Partners (also known under the name of Stanfield Global Strategies) in its capacity as the manager of Victoria Finance.

TruPS CDOs downgraded
Fitch has downgraded US$10bn and affirmed US$435.9m of rated notes across 16 CDOs backed primarily by trust preferred securities (TruPS), senior and subordinated debt issued by real estate investment trusts (REITs), homebuilders and financial institutions specialising in mortgage lending. Of the US$3.8bn of previously triple-A rated securities, 8% were affirmed as a direct result of financial guaranty insurance policies, 69.1% were downgraded but remain in investment grade categories and 23% were downgraded to below investment grade. For the remainder of the securities, the current rating actions resulted in downgrades between two and three categories, on average.

Wrapped CDOs hit
Moody's has taken rating actions on 23 tranches of five CDOs wrapped by MBIA Insurance Corp. The move is a result of the agency's modified approach to rating structured finance securities guaranteed by financial guarantors (see SCI issue 112). Moody's initially analysed and continues to monitor these transactions using primarily the methodology and its supplements for ABS CDOs.

EDS CDOs impacted by negative stock moves
Moody's has downgraded its ratings on 36 classes of notes and six loan facilities issued by CEDO. At the same time, the agency has downgraded four classes of notes issued by Edelweiss Capital.

Both transactions reference a portfolio of equity default swaps (EDS). The primary performance indicator of an EDS is the barrier, which is the initial barrier multiplied by the ratio of the EDS price at closing and its current price. Stock prices are adjusted when corporate actions affect a reference entity according to the ISDA Equity Derivatives Definitions.

Moody's rating actions are the result of an adverse evolution of the underlying portfolio shares, which could cause losses to the impacted notes.

CS & AC

CDS

Understanding basis for discount bonds - part 2

In the second of this two-part series, Barclays Capital quantitative credit strategists Arup Ghosh, Matthew Leeming and Graham Rennison discuss the impact of factors, such as funding costs and interest rates, on the Basis Representation Diagram (BRD) framework

How can BRD incorporate funding levels?
For our analysis so far, we have assumed that the buyer of the basis package can fund at the swap rate. Clearly, in the current environment, this is unlikely to be the case. Here we show how the BRD approach can be extended to include different client funding levels.

In Figure 15 we return to the BRD for the Cable & Wireless package (see last week's issue) for two investors: one funding at Libor and the other at 200bp over Libor. Not surprisingly, the effect of the increased funding cost is to push the whole distribution towards lesser returns. In this example, the returns profile remains positive (albeit less attractive), even in the case of no default.

If we instead take another look at the Iberdrola example (see last week's issue), for an investor funding at 200bp over the swap rate (Euribor), the story is quite different. Given the low basis, and thus low expected returns of this package, funding costs are of overwhelming importance in trade considerations. Figure 16 indicates how this package is almost certainly a losing proposition for an investor with high funding costs.

How does BRD relate to traditional basis measures?
Traditionally, investors have used various measures like the Z-spread and asset swap spreads to measure basis and judge relative value between packages. Focus tends to be on just one number rather than on a distribution, as in the case of BRD. This approach works for bonds close to par, as indicated in Figure 17 for the Iberdrola example.

In this case, all different measures coincide at the returns expected on the package at redemption. For bonds trading away from par, however, traditional basis measures do not necessarily provide a meaningful interpretation of the returns on a basis package.

Figure 18 highlights this for the CWLN example. In such cases, the BRD becomes indispensable for proper analysis of trade returns.

In Figure 19 we indicate how measures based off the Z-spread perform at indicating returns on a wide set of bonds. For bonds trading close to par, the Z-spread measure is a good indicator of the returns expected of the basis package at redemption, as indicated in the left hand graph. However, for issuers with high CDS spreads and bonds trading away from par, the right hand graph indicates how this measure is less reliable in interpreting returns.

Constructing the BRD from traditional measures
Despite the fact that traditional measures deviate in accurately representing returns on basis packages for bonds trading away from par, these measures can actually be used to construct the BRD. Returns on a basis package (buy one bond, and buy 100% notional of CDS) that redeems at maturity is given by



where P is the market dirty price of the bond, s_A is the par asset swap spread and s_CDS is the market CDS spread².

In fact this result can be generalised further to give returns on the package, on any default time 't' of the bond as

where s^t_A is the par asset swap spread calculated for an identical bond, but with a maturity set equal to the default time.

This is an extremely powerful result. The entire distribution of possible returns (expressed as amortised risk-free spreads) of the basis package is defined precisely by calculating the par asset swap basis, normalised by the bond price, at every possible default date.

Anyone with access to an asset swap calculator can therefore easily determine the value of the possible outcomes. This can be overlaid with either default probabilities backed out from the CDS curve or the investors' own estimates of default probabilities to analyse the basis trade. Bloomberg functions like ASW & CDSW can be used to run through these calculations.

BRD applied to relative value between packages
To easily use the BRD to analyse several potential trades at the same time, we recommend summarising the available information using the following three points for each distribution:

• Returns on redemption:

• Returns on default in one year³: 

• CDS implied expected returns:

Of course this is an approximate reconstruction of the BRD and does not explicitly state the market-implied probabilities of different default scenarios. However, we feel this provides a powerful tool to analyse single names and, more importantly, to compare and contrast multiple basis trades.

Using BRD to compare basis trades
Figure 20 presents the condensed BRD for 12 different packages all with CDS trading below 650bp on 4 December. In this representation, the vertical light blue lines indicate the range of returns that can be expected on each basis package: ranging from default in one year to redemption at maturity. The dark blue horizontal lines indicate the expected return on each package.

The packages are arranged in increasing order of bond maturity. As is immediately evident, such a method of comparison provides a powerful tool to analyse and compare different basis trades.

The BRD framework can of course be used to analyse bonds in any currency. Figure 21 shows the relative value analysis of some US bonds trading at various different CDS spreads. Of course it is not possible to compare directly basis trades with bonds denominated in different currencies, as that would also involve accounting for FX risk.

Distressed names trading upfront
The BRD is probably most important as an analytic tool for packages with deeply discounted bonds. In such cases, the traditional measures can be expected to be widest off the mark. Often the CDS on these names trade upfront and that adds another layer of complexity.

In Figure 22 we compare 11 basis trades (buy one bond, and buy 100% notional of CDS) with CDS trading at upwards of 650bp, for both running and upfront CDS. The analysis and results are similar to that performed for the Glencore bond earlier, but here we extend it into a relative value framework.

As is evident from the BRD of running CDS, for many of these cases the returns in case of a default in the short term are extremely attractive. However, in the most attractive scenarios, it also becomes evident that if a default does not happen and the bond goes on to redeem at maturity, the investor loses money, primarily because of the high premium paid on the CDS leg.

In effect, for such high spread names trading with running spread, the returns distribution becomes dispersed, with the possibility of high returns as well as that of loss. This effect changes when we look at the same basis packages, but trading on upfront CDS, rather than running. Here, as before, we find that upfront CDS reduces the returns dispersion on a trade.

Distressed names trading with a 'positive' basis
In the current environment, there are also some anomalies where - despite the bonds trading deeply discounted - the CDS spreads are so high that the basis using traditional measures is actually positive. We highlight a few such names in Figure 23. It is also important to consider that at least two of these names probably traded upfront at these levels.

Under such circumstances, the only reasonable analysis that can be done is by using a BRD for these names. Figure 24 plots the BRD for these five names. As is evident, even these positive basis names can well make money through so-called 'negative' basis packages, in which the investor buys the bond and 100% notional of CDS protection.

These examples highlight further how traditional basis measures fail to provide a true picture of a basis trade, when the bond trades away from par, and especially if CDS trade upfront. The traditional nomenclature of 'positive' and 'negative' basis trades lose their meaning, and the only way to do an accurate analysis is to look at the full distribution of returns.

Footnotes
² Note the par asset swap spread divided by the bond dirty price is simply the market value (or true) asset swap.
³ s¹_A^yr gives the asset swap spread for a one-year bond with identical parameters as the bond being analysed.

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

Trading

Trading ideas: relative health

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Universal Health Services

The credit and equity markets disconnected significantly this year. Currently, most names have CDS trading too tight compared to their equity-implied fair value.

Last week, the markets began to come back together. However, we still see a sizable difference between Universal Health Services (UHS) fair and market levels, and we recommend buying CDS protection and buying equity on the name.

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 beginning of the year, UHS's CDS has outperformed its equity and now UHS CDS trades well below our modeled fair value. UHS trades even farther below its expected level, according to our directional credit (MFCI) model. While an outright short position is attractive on the name, we like taking relative value positions, given the current volatility in the markets.

Exhibit 2 charts UHS market and fair CDS levels (y-axis) versus equity share price (x-axis). The green triangle indicates our expected fair value for both CDS and equity when CDS, equity and implied vol are valued simultaneously. The red triangle indicates the current market values for CDS and equity, whereas the red line is the modeled relationship between CDS and equity.

Exhibit 2

With CDS too tight compared to equity, we expect a combination of equity rally and CDS widening. Our model also points to a drop in at-the-money vol. However, our analysis of a fair implied volatility curve does not indicate much movement away from the current vol curve and we therefore use equity shares as the equity leg for our trade rather than equity options.

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.

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 UHS. UHS is a reasonably liquid name and CDS bid-offer spreads are around 20bp.

Buy US$10m notional Universal Health Services Inc. 5-Year CDS at 215bp.

Buy 29,000 shares Universal Health Services Inc. at US$36.90 to pay 215bp 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).