Contents

CLOs

Natural fit

Private equity/loan investors tipped as new CLO investor base

Private equity firms and traditional loan investors are being tipped as a potentially significant new buying source of triple-A leveraged loan CLO paper, as volatility in the market continues to result in heavy discounts. At the same time, a number of traditional CLO managers are exploring alternative ways of raising funds - typically via unlevered vehicles - thereby tapping into a new investor base.

Many private equity institutions are already buying back loans from bank balance sheets and, according to Merrill Lynch CDO analyst Nicolas Gakwaya, it is only a matter of time before they move up the learning curve and start purchasing loans under the credit-enhanced, structurally protected format that leveraged loan CLOs offer.

Indeed, one structured credit investor notes that interest from the private equity arena is already present and, in some cases, potential investors are willing to look across the capital structure, not just at triple-As. CLO traders also confirm that they are receiving interest across the capital structure from new accounts, but paper is generally failing to trade because the bid/offer spread remains too wide.

"Private equity is a natural fit for CLO debt investments," says Gakwaya. "With weak demand and ample secondary supply, driven by forced sales and liquidations, the supply and demand equilibrium remains skewed towards buyers. As opposed to the very competitive bidding environment of the boom years, the cash investor now has the final say on credits, structures and yield targets."

He also suggests that traditional loan investors may wish to increase their allocation to CLO investments. "While loan investors would sacrifice the greater liquidity offered by the loan product, they would reduce the volatility of total returns (as triple-A CLO principal is returned in nearly all of our envisioned scenarios, compared to a more fluctuating capital return outlook in the case of direct investments) and gain protection against worse-than-expected loan markets underperformance," he adds.

In terms of valuations, Gakwaya says that due to the deep discounts available at triple-A and double-A levels, and despite a much lower coupon than direct investments, senior CLO debt may be an attractive alternative to underlying loans - which may themselves outperform equity investments over the loan maturity horizon.

"Equities, loans, bonds...everything is becoming blurred in terms of what returns an investor can get," notes Zeshan Ashiq, founding partner of Shooters Hill Capital. "It makes sense to centralise everything so the investor - whether it be a loan investor or private equity investor - can get a clear view of everything that is available, no matter what sector it falls under."

Meanwhile, the formation by CLO managers of low-levered or unlevered funds could lead to a new source of CLO investors in the long term, according to one investment advisor. "If the managers are able to get the new investors interested and comfortable with what they do, they may be able to convince them to invest in their CLOs once the market settles down and primary issuance returns," he concludes.

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Monolines

Definitely maybe

Good news at last for the beleaguered monolines?

Positive news could finally be on the cards for monolines and for those entities with exposure to them. While the restructuring and subsequent upgrade of CIFG last week bodes well for other monolines that are currently looking to restructure their portfolios, speculation is growing that US President Obama's new administration could offer help to the sector.

Moody's and S&P last week upgraded the insurance financial strength ratings of CIFG to Ba3 from B3 and to double-B from single-B respectively, with rating outlook developing. The upgrades reflect the strengthened capital adequacy profile of the monoline, following its restructuring and the commutation of almost all of its ABS CDO exposures. The commutation agreement between CIFG, its shareholders and its CDS counterparties totaled approximately US$12bn in notional principal, in exchange for cash and an ownership stake in the CIFG group (see News Round-up for more).

While the restructuring is being seen as a positive for the industry, it is, however, unlikely that the rating agencies will restore CIFG's rating to investment grade - meaning that it is unable to write business and that it remains effectively in run-off mode. "CIFG's restructuring suggests that there may be some hope for the other two most troubled monolines - FGIC and Syncora - that they can restructure successfully," says Michael Cox, credit analyst at RBS. "However, it is unlikely that CIFG - or any other monoline downgraded below investment grade - will regain a rating above that level, at least in the short term."

He adds: "If the performance of the insured assets is better than expected and losses lower than predicted, then maybe. But the rating agencies will be uncomfortable upgrading a monoline to investment grade while there is so much uncertainty, especially as CIFG's remaining portfolio is concentrated on structured finance assets. "

Meanwhile, speculation is mounting that President Obama's new administration will be taking measures to shore up the monoline industry. While nothing is firmly in place yet, two measures could potentially come into force.

First would be the injection of TARP funds as equity for the new municipal bond insurers to be established by Ambac and MBIA (SCI passim). In doing so the funds would support US municipalities by providing cost-effective bond insurance and, more importantly, triple-A rated insurance.

The second action would be the provision of an excess of loss policy for the monolines that could help to stabilise their existing businesses (and therefore ratings). "This would mean banks would no longer have to write down the value of hedges purchased from the monolines, with a beneficial impact on their capital positions," notes Cox. "Indeed, it is feasible that banks would be able to write back up the value of hedges."

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Structuring/Primary market

MAV on the road

Rise in disclosure to offset increased complexity

The transactions arising from the Montreal Accord - Master Asset Vehicle (MAV) I, II and III - finally closed last week, following a restructuring exercise that lasted for over a year and required an extra C$4.45bn of margin facilities (taking the total to C$17.82bn) to be injected at the last minute in order to get the agreement over the finish line. The new MAV notes are more complex than the original ABCP, but it is hoped that increased transparency and disclosure around the underlying assets should offset this.

James Feehely, svp Canadian structured finance at DBRS (which rated the transactions), says that the agency used the same approach for the MAV I and II vehicles as that for CDO-cubed transactions, given that they were backed by CDOs, CDO-squareds and traditional assets. "For MAV I and II, the same pool of assets back the A-1, A-2, B and C notes - unlike MAV III, all 50 notes of which are separate silos (unless they're A/B notes). The idea was for the MAV I and II notes to trade the same and therefore facilitate secondary market liquidity for them," he notes.

MAV I and II represent a significant departure from typical Canadian structured finance transactions because the role of the administrator exposes noteholders to risks not found in triple-A rated structures (prior to 2007, 97% of deals were rated triple-A). BlackRock and TAO Admin Corp are the administrators on the transaction; in contrast to a typical deal that would see BlackRock as administrator sub-contract some of its duties to a sub-administrator, TAO contracts directly with the MAV vehicles.

"This exposes the MAV, and noteholders, to TAO risk," explains DBRS. "TAO is a thinly capitalised entity that does not meet the requirements maintained by DBRS for administrators in triple-A transactions on a stand-alone basis. However, TAO does benefit from a directors and officers insurance policy and in limited circumstances, BlackRock will step in and administer the assets if TAO is unable to perform its duties."

Additionally, in a typical triple-A rated structure, the ability to pay noteholders is a function of the performance of the assets and the role of the administrator is incidental. In the case of MAV I and II, the ability to pay obligations due to noteholders is reliant to some extent on the performance and conduct of BlackRock. Indeed, the payment priorities are non-standard: a C$50m indemnity and uncapped expenses for BlackRock will be paid ahead of interest and principal due on the notes.

DBRS got comfortable with the administrator's indemnity and expenses sitting at the top of the cashflow waterfall by essentially assuming that, given the amount of income that would spin off a vehicle this size (C$32bn), the 10% subordination of the structure and the limit on the indemnity (both in absolute dollar terms and timing that it could impact the waterfall), a truly unexpected event would have to occur before the fees began to impact on interest and principal payments. Such a scenario was driven by the administrator's concern about stepping into a court-supervised restructuring with the potential for lawsuits to be brought.

BlackRock has the ability to manage the assets at its discretion on a broader mandate than a typical managed CDO. "The current theme for manager discretion is not to handcuff the manager and BlackRock prides itself on its expertise in US RMBS - the ineligible assets which back 18 of the 50 MAV tracking notes," explains Feehely.

The legacy ABCP with exposure to leveraged super-senior CDOs has been divided between the MAV I (accounting for 74.5% of the underlying collateral) and MAV II (75.9%) vehicles, whereas MAV III is backed by traditional ABCP assets only. The primary difference between MAV I and II relates to the margin funding facility (MFF): MAV I noteholders must meet specific eligibility requirements and will provide a 'self-funded' margin facility, whereas the MAV II MFF will be provided by third-party lenders (including Canadian banks, certain MAV II asset providers and certain holders of MAV II).

DBRS notes that the credit quality of the underlying asset interests, the probability of the structure facing a margin call that could not be satisfied by available collateral and/or available margin funding facilities, or legal and structural elements of the transaction could act as a ceiling on the rating of the notes. In the case of the MAV I and II transactions, the latter two factors were believed to be sufficient for a single-A rating for the senior notes.

The main lesson to be learnt from the Canadian ABCP restructuring exercise is that investors should demand more disclosure and transparency, according to Feehely. "The most significant contributing factor to the seizing-up of the ABCP market in 2007 was concern about the amount of US RMBS underlying the ABCP, yet the conduit sponsors were reluctant to, and some outright refused to, disclose the detailed nature of the assets."

He suggests that potentially some aspects of the restructuring could be adopted in future CDOs, such as placing an administrator's indemnity at the top of the waterfall. "But the rub is that the transaction would likely not achieve a triple-A rating from DBRS," he comments.

CS

CDO

Bank writes CDO investments down to zero

KBC has written down in full the value of its mezzanine CDO investments, retaining only the super-senior tranches - leading to speculation that other banks could pursue similar strategies, as pressure mounts to mark assets at their 'real' values (see separate News Analysis story). KBC's structured credit portfolio was marked down to €1.9bn, bringing the bank's total markdown for 2008 to €4bn.

The amount for the fourth quarter includes the impact of downgrades of CDO notes (-€0.6bn), the impact of credit spread widening (-€0.3bn) and an increase in the provision for counterparty risk of monoline insurers (-€0.4bn). Another -€0.5bn was added for the full write-down of all remaining non-super senior exposure, partly offset by the reversal of existing deal reserves (+€0.2bn). A sudden rise in asset correlations caused an extraordinary loss of -€0.3bn.

Following the full write-down of the (mezzanine) CDO notes, credit rating downgrades of remaining CDO tranches will have no further impact on their valuation. Moreover, a hypothetical 25% further widening of credit spreads will have an estimated net impact of €-0.2bn on the value of the remaining super-senior exposure.

"We took a conservative stance when marking down to zero all CDO investments which do not have the highest, so-called super-senior status," comments André Bergen, KBC group ceo. "We have also taken decisive measures to reduce costs and to further reduce the risk profile of our activity portfolio. We are pleased to see that the performance in our core markets in Belgium and Central and Eastern Europe held up relatively well. Excluding the impact of the exceptional financial crisis, underlying profit for the year came to around €2.2bn, a positive result achieved in a very difficult operating environment."

He adds that the financial position of the group remains solid after it obtained a commitment from the Flemish Regional Government to an additional €2bn non-dilutive capital-strengthening transaction.

CS

CLOs

Obligor downgrade to test CLO influence on loans

S&P's move to downgrade Ineos Group - the second-largest corporate obligor in European CLOs - to triple-C from single-B minus raises the question as to what extent CLOs could influence the restructuring, workout and reorganisation process of the loan market. Ineos Group's exposure in European CLOs comprises approximately €865m or 1.7% and, according to structured credit strategists at JPMorgan, since the name is such a large obligor in CLOs it will prove to be an interesting test case of how such deals influence the operations of the loan market more generally.

S&P's downgrade of Ineos reflects the unprecedented weak market conditions for petrochemical companies in the fourth quarter of 2008 and the weak outlook for 2009, which could result in severe liquidity pressure for Ineos as a result of its highly leveraged financial structure, the rating agency says. Ineos will have to renegotiate with lenders in April to obtain a longer-term covenant framework.

S&P anticipates a risk that these negotiations could also include some debt restructuring. The agency expects Ineos to face very challenging operating trends in 2009 and 2010, given weaker economies and the petrochemical downturn. JPMorgan analysts remain negative on Ineos as a whole and believe that either the risk of a liquidity problem or covenant breach would force the company into negotiations with its creditors even before the mid-April deadline.

Rumours about another CLO obligor, Ferretti, having downgrade potential thanks to non-payment of interest circulated yesterday (27 January). However, the name is much less common in European CLO deals, with analysts estimating that it has around a quarter the presence of Ineos.

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Indices

CDS indices to track performance of equity names

S&P Index Services has launched its CDS US Indices offering, designed to track the performance of the reference entities of an equity index (see SCI issue 113). The service comprises three indices: the S&P 100 CDS Index initially consists of the 80-90 members of the S&P 100 that have CDS with sufficient liquidity; the S&P CDS US IG Index consists of 100 equally-weighted investment grade US corporate credits; and the S&P CDS US HY Index consists of 80 equally-weighted high yield US corporate credits.

"The S&P 100 CDS Index is the first index to track the performance of the reference entities of an equity index," says James Rieger, vp of fixed income indices at S&P Index Services. "With this first-of-its-type index, Standard & Poor's is providing market participants with a view of the relationship between the equity market and the CDS market for the S&P 100 constituents."

Each index will offer three calculations that reflect the performance of a basket of single name CDS. The first type of calculation, consistent with industry standards, removes a reference obligation from the index upon a credit event.

The second type (event inclusive indices) will augment its calculation of the performance of the CDS indices by incorporating the effect of credit events and corporate actions on the affected issues. Finally, the third type (rolling indices) will calculate the performance of each CDS basket on a continuous basis.

While the S&P 100 Index has fallen by almost 9% this year, the cost of buying default protection on the S&P 100 entities (as measured by the S&P 100 CDS Index) has risen to its highest point of the year - 146bp. Volatility in the CDS market can be underscored by the fact that the lowest cost of buying default protection was measured at 120bp on 7 January (when the S&P 100 equity index closed at 429.84), while the cost of buying similar default protection on 31 December (as represented by this index) was 142bp when the S&P 100 Index closed at 431.54.

"With the launch of the S&P CDS US Indices, Standard & Poor's is responding to the market's need for transparent and objectively run credit default swap indices," continues Rieger. "Working closely with market participants, Standard & Poor's designed the Indices to track the most liquid credit default swaps and be efficient enough to support investment products such as index funds, index portfolios and derivatives."

S&P is using CMA DataVision as its primary source of pricing for the indices, while software from SuperDerivatives has been chosen to calculate them.

CS

Real Estate

Real estate derivatives exchange launches

Details have emerged of a new real estate securities and derivatives exchange dubbed International Real Estate Securities Exchange (IRESE). The aim of the exchange is to allow mortgage bankers to securitise real estate loans and insure against mortgaged property value decline, while accredited investors can invest in residential and commercial real estate securities and derivatives to benefit from real estate price changes, portfolio diversification and fixed income return.

According to Vlad Krutik, IRESE ceo, there are tremendous financial advantages to mortgage bankers and investors that participate in real estate securities exchange through a standardised buy/sell environment that is regulated by federal and state agencies. "In addition to real estate options contracts, IRESE offers an alternative way of mortgage loan securitisation," he notes.

He adds: "It allows investors to pick and choose a risk profile based on individual loan criteria and construct an optimal investment portfolio. Ongoing liquidity is provided by investor trading on the exchange. Investors will benefit from returns associated with investing in real estate and will be able to diversify their investment portfolios."

The internet-based exchange enables participants to buy and sell partial interests in individual residential or commercial real estate mortgages via 'Real Estate Notes' and 'Real Estate Options' contracts.

"To date, there is no straightforward way to insure against property price declines and leverage property equity debt-free," states Rossen Valkanov, an associate professor of finance in the Rady School of Management, UCSD. "But one can construct a position, which allows property owners and investors to benefit from changes in the value of the underlying asset, a real estate property. At the same time, the risk of price decline can be transferred from the property owner to investors for a price. IRESE developed a system by which one can apply options contracts to individual real estate properties."

CS

Distressed assets

Bringing clarity to chaos

Hansol Kim, founding partner of structured credit advisory firm Pine Lakes Capital, answers SCI's questions

Hansol Kim

Q: How and when did Pine Lakes Capital become involved in the structured credit market?
A: Pine Lakes Capital launched at the end of 2008. Having spent the last 14 years of my career at Financial Security Assurance, I felt I had something to offer the market in these distressed times and wanted to build a platform through which I could stay on top of the market and in tune with its participants.

For the first seven years at FSA, I mainly focused on the consumer ABS side of the business. In the latter half, a significant amount of my time was spent on developing and underwriting CDOs.

FSA intentionally stayed away from ABS CDOs, so the focus was on CLOs and super-senior correlation trades. Given the explosive growth in the CLO sector over the last three to four years, I was personally involved with underwriting approximately 30 CLOs during that time. During my tenor at FSA, I was responsible for underwriting over US$50bn in transaction volume of structured finance securities.

There are some real opportunities in the market - a lot of assets are trading at very distressed levels. Certainly, for many assets the deep discounts are fully justified, but with respect to others, from my viewpoint as a credit underwriter, they do not deserve to be tarnished with the same brush.

There are assets that we have intimate knowledge of and even the very deals that I helped underwrite are trading at deeply discounted levels, not necessarily for credit reasons. Obviously, the real trick is in knowing how to separate them into 'the good, the bad and the ugly'.

Pine Lakes' goal is to bring to the table the insight and knowledge of the structured market. Until there is a two-way market and price stability and transparency, market confidence will not return. We would like to bring some clarity to the current chaos.

I am expecting two or three other members to join Pine Lakes by the end of January or the beginning of February.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: Right now my clientele fall into two distinct groups: one is those entities that already have exposure to structured finance securities - such as those with portfolios of ABS, but who do not necessarily have the in-house expertise or tools to fully understand the ins and outs in a stressed environment. The other group is those that are seeing the current dislocation in the structured finance market and want to take advantage of it - such as distressed funds and hedge funds.

Obviously, few funds are able to raise new capital at the moment, but in some cases we do see hedge funds with pockets of money in existing in funds and they want to put this money to work in the structured finance arena. Pine Lakes allows them to outsource product knowledge, without staffing up.

Ultimately, the most interesting route would be to manage these assets ourselves. We are in preliminary talks with some Asian investors to try and ramp up a fund. You can see the consulting arm of Pine Lakes Capital as phase one, with phase two incorporating portfolio management.

Q: What is your strategy?
A: In the current environment I think we need to stick with stable assets. Yes, it could be interesting to purchase an ABS CDO tranche for pennies on the dollar, which could make 200% or nothing at all. But that is not what I'm after at the moment.

My target is buy-and-hold CLOs or consumer ABS assets. Consumer ABS assets in particular have a very short average life, which in a mark-to-market environment like the one we are in now can be a positive.

CLOs in the past proved be a stable asset class. Even with the recent overall weakening in the leveraged loan market, we believe that CLOs will be resilient, both on a relative and absolute basis. We also believe that consumer ABS and CLOs have more transparent structures that investors can really tap into.

Q: How do you differentiate yourself from your competitors?
A: I think the main difference is our independence and objectivity. We don't make money crossing bonds or pushing certain products.

Since the only source of revenue for Pine Lakes are institutions that hire us to provide analyses and recommendations, our interests are completely aligned with those of our clients. Also, a larger institution may not be able to speak up against the rating agencies, even if they spot something, given other areas within that organisation which may be dealing with the agencies.

We also distinguish ourselves based on the type of assets on which we advise people. A number of firms concentrate on RMBS, which I think is too volatile and risky, even at the current prices. We are trying to focus on more stable buy-and-hold portfolios rather than those that you might have to suddenly trade out of.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
A: I think the biggest hurdle is that we need financial institutions to come clean in regards to losses. Until everyone comes clean, the current crisis will not go away.

People don't feel confident that the losses reported last quarter are the end of the story. I know it's in human nature to avoid delivering bad news and I understand the reality of running public companies, but 'bleeding slowly' is the last thing we need if we wish to get on the path to recovery.

However, one positive development is that people are credit-focused once again, going back to basics. Risk is forcing everyone to rethink and reassess their assumptions and reality.

There were plenty of transactions I turned down in my former life, which were gobbled up by someone else. Even within the CLO space, investors over the last several years did not differentiate between CLO managers.

There was a sense, both by portfolio managers and investors alike, that anyone could manage leveraged loans. We will certainly be testing this theory in the near future and some investors are not going to be pleased. Of course, we will revert to this euphoric state of invincibility once again when the market recovers, but for now we seem to have got the message.

Q: What major developments do you need/expect from the market in the future?
A: First, we need the market confidence to come back - that will depend on how quickly banks can clean up their books and how the current credit cycle plays out. That will go a long way to price stability, which in turn will lead to buyers coming back.

I think we are also going to see a tighter regulatory environment that will hinder, in the short term, the growth of the market. However, this, in the long run, will be beneficial as investors and other industry participants are forced to properly do due diligence and assess risk in an orderly fashion.

About Pine Lakes Capital
Pine Lakes Capital is a consulting and advisory firm dedicated to finding customised solutions with respect to all aspects of structured credit product investments and portfolio analytics.

AC

Firm hires, launches new distressed fund

The latest company and people moves

Firm hires, launches new distressed fund
NewOak Capital has appointed David Bigelow as md of marketing, covering institutional clients such as pension funds, public funds, endowments, private equity and financial institutions. NewOak Capital is also launching a distressed long/short strategy investing in high yield corporate and leveraged loans in separate account format for its institutional clients, headed by Mark Pibl, md.

Bigelow has 22 years of experience, most recently at Clinton Group, where he was a product manager for the CDO programme, handling negotiations, structuring, marketing and investor relations for ABS and corporate CDOs.

UK asset manager hires six for ABS push
Threadneedle has made six ABS appointments in its fixed income team. Andrew Bristow, former ABS and MBS trader at Goldman Sachs will lead ABS investment in London as an executive director. He is joined by a specialist ABS team acquired from Babcock and Brown in Australia.

The team from Babcock and Brown comprises five investment professionals who specialise in the mortgage and structured product arena with an average of 10 years' experience. The team will be jointly led by Steven Fleming and Ashley Burtenshaw. In addition to hiring of the new team, Threadneedle will take over the management of US$1.8bn in assets from Babcock and Brown on an advisory basis.

"We believe there is a real opportunity to be seized in this specialist market and that our clients will benefit from this added expertise. "comments William Frewen, head of fixed income at Threadneedle.

Manager misrepresents funds' underlyings
A fund manager whose funds collectively lost US$2bn in 2007 has been shown to have misrepresented hundreds of millions of dollars of illiquid, lower-rated ABS as corporate bonds and preferred stocks in its SEC filings - thereby making the funds seem more diversified and less risky than they were. In some cases the ABS were backed by sub-prime mortgages or CDS.

The Securities Litigation and Consulting Group (SLCG) has issued an updated report on six Regions Morgan Keegan (RMK) bond funds: Advantage Income Fund (RMA), High Income Fund (RMH), Strategic Income Fund (RSF), Multi-Sector High Income Fund (RHY), Select High Income Fund (MKHIX) and Select Intermediate Bond Fund (MKIBX). The report concludes that losses suffered by investors in these funds were not the result of a 'flight to quality' or a 'mortgage meltdown'. It also illustrates how, contrary to SEC guidance, RMK repeatedly compared the performance of its funds to an index - the Lehman Brothers Ba Index - that contained only corporate bonds and no structured finance securities, despite the fact that the funds invested 60% to 70% of their portfolios in structured finance.

In addition, the study reports that Morgan Keegan (the broker-dealer) misled investors by comparing the performance of the Select High Income Fund to the CSFB High Yield Index, which - like the Lehman Brothers index - contained none of the securities that dominated the RMK fund's portfolio.

CDO manager replaced
The portfolio manager of Mainsail CDO I, Solent Capital, was replaced by Cairn Financial Products as of 22 January. Solent was removed as manager following a fall below 100% of the Class A/B par value ratio.

Bank loses CDO trader
Aynur Mukhametshin, vp and prop CDO trader at Merrill Lynch is understood to have left the bank. In the past Mukhametshin held similar roles at Renaissance Capital and JPMorgan.

CDS structurer on the move
David Carlson, a credit derivative structurer at JPMorgan, is understood to have left the bank.

Ex-Lehman md hired for distressed credit role
Christine Daley, former co-manager of the distressed debt and special situations prop desk at Lehman Brothers has joined Oak Hill Advisors as md where she will focus on the distressed credit markets.

MBS sales head hired
Amherst Securities has hired Blake Myers as a salesperson. Myers, who is based in New York, previously worked at UBS in MBS sales. While at UBS, Myers managed a sales team that worked with clients in various sectors, including insurance companies, money managers and hedge funds. Prior to working at UBS, he held a similar role at JPMorgan from 2000 until 2003. From 1993 until 2000, he was an MBS salesman at Nomura.

Bank exits structured finance business
UBS has confirmed that it is to exit its real estate, securitisation and exotic structured products businesses within the Fixed Income, Currencies and Commodities Group. UBS' credit head Chris Ryan is to leave the bank as a result of the changes. The CLO business, led by Simon Perry was shut down in October last year.

Coventree to wind down operations
Coventree Inc. is to wind down its operations following the finalisation of the restructuring of the market-disrupted Canadian ABCP. The company will reduce its workforce, including senior officers, as and when their services are no longer required by the company to meet the company's obligations under the transition services agreement or to complete the wind down of the company.

Knight promotes two
Knight Capital Group has promoted senior mds Gary Katcher, head of global fixed income, and Steven Sadoff, cio, to evps. Katcher joined Knight in July 2008 with the company's acquisition of Libertas Holdings, LLC, renamed Knight Libertas LLC. Founded by Katcher, Knight Libertas provides trade execution services and investment research to institutions across a broad range of fixed income securities, including high-yield and high-grade corporate bonds, distressed debt, asset-backed and mortgage-backed securities, convertible bonds and syndicated loans. Sadoff has been with Knight since April 2002 and is responsible for all technology, information, operations, and facilities for the firm.

Babson expands Global Business Development group
Babson Capital has added two members to its recently-created Global Business Development Group. Paul Gehrig has been hired as a product manager, responsible for the development and distribution support of corporate-bond-backed funds and separate accounts. These include cash and synthetics. David Acampora has joined Babson Capital to develop and manage relationships with investment consultants.

Prior to joining Babson Capital, Gehrig was an md in structured credit products origination and execution at Wachovia. Acampora was previously md at Commonfund, working with nonprofit groups in a business development and relationship capacity.

Firm adds to trading and structured sales groups
Broadpoint Capital is expanding its ABS/MBS trading division, Broadpoint DESCAP, whilst launching a new Repurchase Desk and expanding its Structured Products Group. Broadpoint DESCAP's Repurchase Desk will be led by Joanmarie Pusateri, a former Bear Stearns md.

Joining Broadpoint DESCAP's Structured Products Sales Group are : P. Read Burns, formerly of Lehman Brothers where he most recently focused on MBS and ABS sales; Jisook Choi, who joins from Bear Stearns where she marketed and originated various types of structured products including cash, synthetic and esoteric transactions; James Hurst, who most recently worked in structured products at Barclays Capital; Michael Petrucelli, who joins from Lehman where he was svp and structured products and loan salesperson for seven years; and John Rozario, who joins Broadpoint from Merrill Lynch where he worked in the structured credit products sales group. Prior to Merrill, he worked for several years at CIBC World Markets in its Structured Credit Products group, where he led a team responsible for origination, structuring and distribution of structured financing solutions for institutional clients.

CLO manager comments on 2009 plans
ICG, the mezzanine and leveraged loan investor and CLO manager saw its share price drop earlier this week following the announcement of its interim management statement for the three months to 31 December 2008.

The firm expects 2009's net new investments to be limited to the secondary market for senior loans where it says it is finding excellent value. "Core income in the second half is expected to be slightly lower than the level achieved in the first half (adjusted for one off contributions announced at the Interims), as we do not accrue rolled-up interest on impaired assets," it said in the statement. "We currently anticipate that provisions will be noticeably higher than in the first half due to the impact of the worsening economic environment on our weaker assets and the strength of the Euro against Sterling. Capital gains are expected to remain at the low level experienced in the first half."

ICG will continue to market its Recovery Fund (See SCI 120) and it is aiming to reach a final close in the first half of next financial year. It also expects its Eurocredit Opportunities Fund, which is subject to mark to market covenant tests, to be further restructured to strengthen the fund.

Capital markets business sold
Sanders Morris Harris Group is to sell a significant portion of its Capital Markets business, including the investment banking, fixed income, and New York-based institutional equity departments, to Siwanoy Capital, a company formed by the senior management of the units and Pan Asia China Commerce Corp (PAC3). The terms of the transaction were not disclosed.

The transaction will transform Sanders Morris Harris Group almost entirely into a wealth/asset management company with approximately US$10.2bn in client assets as of September 30, 2008. The Company announced in August 2008 that it was exploring strategic alternatives for its Capital Markets unit.

The sale is expected to close in the second quarter of 2009 upon the formation of a new broker-dealer by Siwanoy Capital. Sanders Morris Harris Group will retain a 20% interest in the business, subject to PAC3 having an option to purchase that interest. The sale does not include Sanders Morris Harris Group's Concept Capital prime brokerage division or the Los Angeles-based Juda Group. Concept Capital also anticipates forming a broker-dealer and becoming a stand-alone company, of which Sanders Morris Harris Group will retain a 50% ownership interest.

Global Content Operations head appointed
Fitch Solutions has appointed Simone Warner as a senior director and head of its Global Content Operations. In this new role, Warner will manage Fitch's internal content teams and be responsible for all the content requirements of both Fitch Solutions and Fitch Ratings, including data quality, content integration and coordinating content outsourcing. Based in London, Simone will report to Thomas Aubrey, md, Fitch Solutions.

Prior to joining Fitch Solutions, Warner was vp of Fixed Income Content Strategy for Investment & Advisory at Thomson Reuters and has nearly 20 years experience managing fixed income content teams and budgets at both Reuters and Thomson Financial.

New ceo for monoline
John Pizzarelli's role as CIFG ceo is ending upon the successful completion of a settlement reached between CIFG and its derivatives counterparties and insured bondholders on the company's troubled structured finance portfolio. (See News round up for more). The company has named Lawrence English as his replacement.

English is ceo of Lawrence P. English, Inc., a renewal and turnaround management firm. He also held the role of chairman and ceo of QuadraMed Corporation from 2000 to 2006, leading a turnaround of that troubled company.

ING illiquid asset back-up facility agreed
ING and the Dutch government have reached an agreement on an illiquid assets back-up facility covering 80% of ING's Alt-A mortgage securities. The transaction is expected to significantly reduce the uncertainty regarding the impact on ING of any future losses in the portfolio.

Under the terms of the facility, a full risk transfer to the Dutch State will be realised on 80% of ING's €27.7bn portfolio of Alt-A RMBS at ING Direct USA and ING Insurance Americas. The Dutch State therefore will participate in 80% of any results of the portfolio. This risk transfer will take place at a discount of 10% of par value.

ING will remain the legal owner of 100% of the securities and will remain exposed to 20% of any results on the portfolio. The Dutch State will be entitled to receive 80% of the cashflows of the total portfolio.

Omnibus claim filed for LBIE customers
The administrators of Lehman Brothers International Europe (LBIE) have advised that they will be filing an omnibus claim on behalf of LBIE and LBIE's customers against Lehman Brothers Inc (LBI) in its liquidation proceedings under the Securities Investor Protection Act of 1970 (SIPA).

On 19 September 2008 the US District Court for the Southern District of New York granted a Protective Decree ruling that customers of LBI are in need of protection under SIPA. The deadline for customers of LBI to file claims is 30 January, 2009.

A customer claim under SIPA is a claim of any person or entity on account of securities received, acquired, or held by LBI in the ordinary course of business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral security, or for purposes of effecting transfer. The administrator's omnibus claim will cover LBIE's customers whose cash, securities or other assets were (or should have been) held by LBI on the filing date. The administrators' claim will not include cash, securities or other assets that were booked by customers directly with LBI.

Interactive Data promotes Duggan
Interactive Data has promoted Liz Duggan to chief operating officer, Evaluated Services. In this newly created role, Duggan and her team will work with clients to accelerate the development of new services and the addition of new capabilities. Duggan joined Interactive Data in 1999 and has held several roles within the company. In her most recent position as vp, market specialists, she cultivated client relationships and contributed to the growth of the company's institutional business. She reports directly to Shant Harootunian.

AC & CS

CIFG restructured and upgraded

A round up of this week's structured credit news

CIFG restructured and upgraded
Moody's and S&P have upgraded the insurance financial strength ratings of CIFG to Ba3 from B3 and double-B from single-B respectively, with rating outlook developing (see also separate News Analysis story). The actions reflect the strengthened capital adequacy profile of CIFG following its restructuring and the commutation of substantially all of its ABS CDO risks.

The commutation agreement between CIFG, its shareholders and its CDS counterparties resulted in the termination of substantially all of the monoline's ABS CDO exposures (totaling approximately US$12bn in notional principal), in exchange for cash and an ownership stake in the CIFG group. The roughly US$1.3bn cash payment from CIFG to its CDS counterparties is considerably lower than CIFG's reserves on these exposures, freeing up claims paying resources and restoring the firm's regulatory capital position above minimum levels.

In addition to the commutation agreement with its CDS counterparties, CIFG has ceded approximately US$13bn in municipal exposure (representing most of its US municipal book) to Assured Guaranty Corp. Following these transactions, CIFG's remaining insured portfolio totals roughly US$60bn and includes approximately US$40bn in CDO exposure and US$3bn in US RMBS risk. The agencies believe that the monoline now has claims paying resources that exceed expected losses in its retained portfolio.

The CDS counterparties' ownership stake in CIFG approximates to 90% in aggregate, with Caisse Nationale des Caisses d'Epargne Prevoyance (rated Aa3/P-1/C+) and Banque Federale des Banques Populaires (rated Aa3/P-1/C+) retaining about 5% each.

Moody's notes that the terms of the CDO commutation may nonetheless have some elements that are typically associated with a distressed exchange, though such a determination is ultimately a matter of judgment.

The developing outlook for the monoline reflects a capital adequacy profile that is broadly consistent with a low-investment grade score, recognising, however, that the insurance portfolio remains exposed to substantial performance volatility in light of its concentrated exposure to structured assets and stressed mortgage risks - some of which are quite large relative to capital. There is also some uncertainty with respect to CIFG's operational plans over the medium term, given the guarantor's limited strategic relevance to its new and diverse ownership group.

Smurfit-Stone protocol announced...
ISDA is to launch a CDS auction protocol to facilitate the settlement of credit derivatives trades referencing Smurfit-Stone Consolidated Enterprises Inc, the Chicago-based leading integrated containerboard and corrugated packaging producer. Smurfit-Stone has announced that it and its US and Canadian subsidiaries have filed voluntary petitions for reorganisation under Chapter 11 in the US Bankruptcy Court in Wilmington, Delaware. The Canadian subsidiaries will also file to reorganise under the Companies' Creditors Arrangement Act (CCAA) in the Ontario Superior Court of Justice in Canada.

In addition, LCDX dealers are expected to vote shortly on whether to hold an auction for loan-only CDS transactions referencing Smurfit-Stone. If those firms vote to hold an auction, ISDA will publish auction terms for this auction, similar to the documentation for the recent Tribune loan-only CDS auction that took place late last year.

...while LCDX dealers vote to hold Credit Event Auction
Markit LCDX index dealers have voted to hold a Credit Event Auction to facilitate settlement of LCDS trades referencing Smurfit-Stone Container Enterprises, which is a constituent of the Markit LCDX index. The auction terms, including the auction date, will be determined by Markit LCDX dealers according to LCDS Auction Rules published on ISDA's website. Markit and Creditex are the official administrators of Credit Event Auctions.

CMBX delinquencies slow (for the moment) ...
The pace of new delinquencies across the Markit CMBX index slowed in January versus the prior month, but remains well above historical seasoning patterns, according to structured finance analysts at Barclays Capital. After a 43bp increase in the average non-performing loan rate across all series in December, the index saw a 20bp climb this month.

New delinquencies were concentrated in CMBX.2-4. The analysts expect the pace of new delinquencies to intensify throughout the year, however.

Weakness is expected to continue in the retail sector, especially single tenant collateral, which is suffering from a wave of tenant bankruptcies. The risk of single tenant collateral was highlighted this month, for example, by Boscov's related loans in BACM 06-3 in CMBX.2, where interest shortfalls reached investment grade classes (originally triple-B rated) owing to appraisal reductions.

Loan performance also deteriorated due to the bankruptcy, and in some cases liquidation, of Value City, CircuitCity, Linen 'N Things, Gottschalks and Mattress Discounters. The analysts note that retailer bankruptcies can spill over into the industrial sector as tenants vacate warehouses and distribution centres.

... while ABX performance deterioration continues
The Markit ABX index continued deteriorating in January, the latest remit figures show - although the deterioration did not exhibit a clear sign of accelerating. Comparing monthly changes, for cumulative loss, the 07-1 and 06-1 indices increased less this month than over the previous month. The 06-2 is showing the sharpest deterioration, however.

Furthermore, the 06-2 index has the lowest voluntary prepayments at 2.32% versus 2.51% for the 07-1, 4.27% for 06-1 and 4.28% for 07-2 - all remarkably low numbers, expressing the lack of refinancing options for sub-prime borrowers, structured finance analysts at JPMorgan note. In addition, after a drop in CDRs last month, all of the indices - except the 06-1 - experienced a pick up in defaults this month.

The number of ABX constituents being written down also continues to increase: 26 triple-B minus and 13 triple-B bonds have now been depleted. The tranche below three additional single-A constituents are currently experiencing a write-down, with the analysts expecting these bonds to be hit in the coming two months.

Lehman CLNs repurchased
Sun Hung Kai Financial (SHKF), the Hong Kong non-bank financial institution, has decided voluntarily to repurchase up to approximately HK$85m of Lehman Brothers credit-linked notes - also known as Minibonds - from a small number of its primary market retail customers. The firm says it has worked tirelessly and in co-operation with all relevant parties - including the Securities & Futures Commission (SFC), the trustee of Lehman Brothers' Minibond Series (HSBC Bank USA) and the HKAB Task Force - to identify a workable solution that appropriately balances the interests of all stakeholders, but in particular its customers.

The repurchase offers will be made at the full principal value of the Lehman Brothers Minibonds held by the firm's 310 primary market retail customers. The repurchase initiative represents the best possible solution for affected customers, according to SHKF, and provides closure for them on the unforeseen and unfortunate events sparked by the global collapse of Lehman Brothers. SHKF says that it does not accept any liability or wrongdoing in regard to this offer, however.

In relation to a reprimand it received from the SFC, SHKF highlights that some of the issues raised date back to 2002 and have since been rectified, while any outstanding concerns are currently being addressed. The firm says it has fully co-operated with the SFC and is committed to ensuring that it operates with the highest standards of conduct and customer service.

S&P reports on rating transitions
In 2008 ongoing constraints in credit availability and the onset of recession in many economies began to have a widespread negative effect on credit risk in European structured finance, reflected in an acceleration of rating downgrades. Although S&P left unchanged or raised 82.2% of ratings over the period, this figure is far lower than has been the case over recent years, compared with 97.7% in 2007, for example.

Initially, rating weakness was limited to certain transactions with direct exposure to the market value risk of financial securities or to certain asset classes in the US structured finance arena. However, as 2008 progressed, S&P found that fundamental credit risks increased across most classes of financial assets relevant for structured finance, such as residential and commercial mortgages, auto loans and corporate credit. In addition, high-profile failures - or at least downgrades - of systemically-important financial institutions also led to increased risk in some securitisations where these entities performed a key role.

Of the 9,320 ratings outstanding at the start of 2008, S&P left unchanged or raised 82.2%, while it lowered 17.8%. This compares with 97.7% and 2.3% respectively in 2007, highlighting a surge in downgrades.

The agency lowered 60 ratings from 45 transactions to single-D during the year, giving a default rate of 0.64%, compared with 0.19% in 2007. Fewer tranches saw a drop in credit risk and consequent upgrade, with the upgrade rate moderating to 1.7% in 2008 from 4.9% in 2007.

Rating transitions during the year resulted in an average decrease in credit quality over all outstanding ratings, equivalent to a downgrade of 1.4 notches - by far the largest annual credit deterioration observed to date. For ratings that were lowered during 2008 the average net downward move was 8.1 notches, significantly higher than the average 3.7 notch downward move in 2007.

By asset class, CDOs exhibited by far the highest downgrade rate and one of the lowest upgrade rates in 2008, with 30.3% of CDO ratings lowered and 1.0% raised over the year. Most defaults occurred among CDOs, generally following breaches of certain triggers related to the market value of underlying assets or default of the collateral.

Of the 161 ratings raised during the year, 65 were on RMBS, 46 on CDOs, 35 on ABS, 14 on CMBS and one was on a corporate securitisation tranche. Of the 1,662 ratings lowered during the year, 1,360 were on CDOs, 170 on RMBS, 68 on CMBS, 47 on ABS and 17 were on corporate securitisation tranches.

Whinstone transactions impacted
Fitch has downgraded the Whinstone Capital Management and Whinstone 2 Capital Management notes, with the outlook changed to negative. These transactions are synthetic securitisations that reference the reserve funds acting as credit enhancement for the notes issued from the Granite master trust programme, which is backed by residential mortgage loans originated by Northern Rock.

Fitch tested the ratings of all outstanding notes issued though Whinstone and Whinstone 2 against its expected UK housing market deterioration, factoring in a decline in UK house prices of approximately 30% from their peak in October 2007, in addition to increasing defaults. The analysis showed that in such a scenario, the transactions are susceptible to negative rating migration. This factor, in combination with the continued deterioration in the underlying collateral performance of Granite backing Whinstone and Whinstone 2, has prompted the downgrades.

The Whinstone notes reference the performance of the reserve funds acting as credit enhancement for the five outstanding capitalist issuances from the Granite Finance Funding platform of Granite. The first layer of protection for the Whinstone notes is a threshold amount equal to the Funding reserve fund, which is defined as 1% of the aggregate outstanding balance of the notes of all the Funding issuers.

The Whinstone 2 notes reference the performance of the Granite Finance Funding 2 reserve fund and the Granite Master Issuer (GMI) reserve fund. Credit enhancement for the notes issued by Whinstone 2 is provided by a static threshold amount of £101m.

Hedge fund withdrawals reported ...
The hedge fund industry concluded the most tumultuous year in its history, with investors withdrawing a record US$152bn in capital in Q408, according to data released by Hedge Fund Research. The HFRI Fund Weighted Composite Index fell by 18.3% for all of 2008, only the second calendar year decline since 1990.

Also during 2008, the industry experienced a period of six consecutive months of declines between June and November, interrupted only by December's 0.41% gain - including a concentrated, volatile two-month period in September and October, in which the cumulative decline approached 13%. With performance down and volatility up, investors withdrew a record US$155bn during 2008, only the second time in which the industry experienced a net outflow of investor capital over a full-year period since HFR began tracking asset flows in 1990.

This capital outflow followed a record year of capital inflows in 2007, during which US$194bn of new capital came into the industry. When combined with the negative performance-based asset flow, total capital invested in the hedge fund industry declined to US$1.4trn at the end of 2008 - a decline of US$525bn from the peak of US$1.93trn recorded at mid-year 2008. Investor redemptions were widespread and indiscriminate across fund strategies, regions, asset sizes and performance dynamics.

Dislocations and sustained volatility across financial markets contributed to record dispersion between individual funds and between fund strategies in 2008; while the bottom 10% of all funds declined an average of 62%, the top decile of all hedge funds gained an average of 40% percent.

... while survey highlights dangers of inadequate disclosure
A new survey from the EDHEC Risk and Asset Management Research Centre, entitled 'EDHEC Hedge Fund Reporting Survey', shows that even before the Madoff scandal, investors were dissatisfied with the quality of information on liquidity and operational risk exposure in the sector and had noted the dangers of inadequate reporting.

The survey, which targeted hedge fund managers, hedge fund investors and fund of hedge fund managers, was taken in the summer of 2008. The first response was received on 4 July and the last on 1 October. Nearly 90% of the 214 respondents to the survey are based in Europe, many of them in the UK, Switzerland and France.

In analysing the industry's spectrum of opinions, the authors - Felix Goltz and David Schroeder - identify critical points of conflict in the alternative investment business. 92% of all industry practitioners believe that the quality of hedge fund reporting is an important signal of a fund's overall quality, and thus pivotal for investors' decisions about hedge fund investment.

However, information disclosure is not viewed as adequate by investors. Although they are satisfied with the information on past hedge fund returns, the information on fund liquidity and operational risk exposure is regarded as incomplete.

The industry views issues related to the pricing and the valuation of hedge funds (identified by more than 76%) as the most crucial elements of operational risk reporting. Information on internal risk management (60%) and internal controls (48%) are also seen as major aspects. When asked whether the information provided on operational risk is sufficient or meets their demands, investors replied that exactly those aspects that are considered most important are those that are considered most wanting; that is, information on a fund's valuation framework and on the internal controls a fund puts in place.

Liquidity risk is considered a major source of risk for hedge funds, especially for hedge fund investors - more than 80% of whom classify this source of risk as "very important". Yet this clear view contrasts sharply with the industry's satisfaction with the current coverage of liquidity risk in hedge fund disclosure. Some 80% of all respondents state that liquidity risk is not sufficiently captured in hedge fund reporting.

Government support has "potential to unlock" market
Fitch says the UK government's various support schemes announced last week (see last week's issue) have the potential to unlock the UK's structured finance and broader credit markets. However, the success of the schemes will depend on the specifics regarding their implementation, which remain unclear at this point. Further announcements detailing the schemes are anticipated from the Treasury in the coming weeks.

"Significantly, the Treasury has announced that the guarantee scheme for asset-backed securities will not be restricted to mortgage-backed assets," says Stuart Jennings, EMEA structured finance risk officer. "Therefore the guarantee scheme could potentially unlock a wider range of capital markets than is currently the case."

Regardless of the scheme, it remains Fitch's view that the risk of loss on existing triple-A rated notes remains minimal. That said, the overlay of a government guarantee for new triple-A rated structured finance notes should provide additional comfort to investors, while posing a minimal risk of losses to the taxpayer.

Meanwhile, the Bank of England's prospective asset purchase facility and the extension of the discount window facility, also announced last week, will step in and maintain liquidity following the expiry of the special liquidity scheme (SLS) on 30 January 2009. Fitch estimates that approximately £230bn of SLS-eligible structured finance notes have been issued since the scheme's inception in April 2008.

Inconsistency between public-placement and repo ratings usage
Fitch says that the eligibility criteria update announced by the ECB (see last week's issue) will have a limited impact on the structured finance usage of its repurchase facility. However, there remains an inconsistency between the use of ratings in the traditional public structured finance market and those for ECB repo purposes. This may prove problematic when the public market re-opens, the agency says.

"The majority of securities placed with the ECB have been triple-A rated anyway, and few, if any, have been ABS CDOs," says Stuart Jennings, EMEA structured finance risk officer at Fitch. "What the criteria update does do though is draw a line in the sand for future issuance, safeguarding the future risk profile of the programme."

Despite market speculation that it would require two ratings in future to address potential 'rating shopping', the ECB has opted to maintain its requirement for only a single rating. This will continue the post-August 2007 trend towards less credit enhancement, as originators only need to meet the credit enhancement requirements of one rating agency rather than two or more.

According to Fitch, it may also exacerbate transition risk when the structured finance sector re-opens and moves back to the pre-August 2007 publicly syndicated market model from the current ECB repo-driven model. "Specifically, the public market has traditionally required two or more ratings. Therefore transactions that have been posted with the ECB may require significant restructuring before they can be transferred to a wider investor base," says Fitch.

In May 2008 Fitch also noted that there was scope in the ECB eligibility criteria for banks to structure riskier transactions in terms of structural features and collateral quality than were typical in the pre-crisis publicly sold European securitisation market. "The previous eligibility criteria had left the door open for banks to securitise more risky, less liquid or data-limited assets for ECB repo purposes," says Jennings. "It is possible that the pool of eligible assets will contract as a result of the new triple-A rating threshold, as certain portfolios of this type may not be capable of achieving a triple-A standard."

Two new modules for CDO Suite
Deloitte has released two new modules for CDO Suite - its asset administration, compliance and reporting system for a variety of portfolio structures, including hedge funds and CDOs - that it says will enable market participants to become either providers or consumers of syndicated loan data.

"Many of our current administrator clients have vast amounts of loan data and cover virtually all active facilities in the syndicated loan market," comments Hillel Caplan, a partner with Deloitte & Touche and the leader of its CDO Suite practice. "Our intent is to give them the ability to make this data more available to appropriate market participants."

The two new modules that are now available are:

• A Data Provider Module, which can be used by administrators to capture syndicated loan activity that is recorded in the administrator's installation of CDO Suite and to automatically produce a customised XML file for each of the administrator's clients that chooses to license data from the administrator. The module can be used to track which facilities each subscriber owns an interest in and signs up to receive data for.
• A Data Subscriber Module, which can be used by buy-side firms and other syndicated loan investors to automatically import the XML data files from the administrator into the subscriber's installation of CDO Suite.

"Given how many administrators use CDO Suite, we are hopeful that our initiative will lead to an increase in the number of administrators that decide to become data providers to the marketplace," adds Caplan.

CRE CDO notes downgraded
In the past week Fitch has downgraded close to US$7bn of CRE CDO notes, reflecting its view on industry and vintage concentration risks outlined in its revised structured finance CDO rating criteria released on 16 December 2008. The transactions are primarily backed by static portfolios of the most junior tranches of CMBS transactions and are pass-through structures without cashflow diversion features. Rating downgrade actions in some cases were a full three categories lower.

Fitch also rates 21 other CMBS B-piece resecuritisations that were structured with cashflow diversion features as additional forms of credit enhancement that will be reviewed separately by the end of Q109.

Key drivers of the actions include industry concentration, which approaches 100% in some transactions, and significant vintage concentrations. Exposure to a single sector of structured finance securities can significantly increase portfolio default rates, as the underlying assets may face the same macroeconomic pressures.

CAM SME CLOs hit
S&P has downgraded or placed on watch negative a number of SME CLO notes issued by Spanish issuer Caja de Ahorros del Mediterraneo (CAM). In particular, notes from Empresas Hipotecario TDA CAM 3, FTPYME TDA CAM 4 and Empresas Hipotecario TDA CAM 5 were affected. The rating actions follow a full credit and cashflow analysis of the most recent transaction information and loan-level data on Spanish SMEs originated by CAM.

S&P states that data provided on the SMEs suggests that each securitised pool contains a higher-than-average portion of loans granted to developers. Those loans, in the agency's opinion, are more exposed to an expected rapid deterioration in performance in the current economic environment.

Outlook for Japan released
In 2008 Moody's rated about Y3trn in structured finance transactions in Japan, down 50% from the previous year, according to the agency's '2008 Review and 2009 Outlook: Japan's Securitisation Market' report. Volume declined significantly across all asset types, especially CMBS.

Moody's sector outlooks across Japanese structured finance asset/collateral performance range from Stable to Negative and differ according to various performance drivers. The agency is maintaining its Stable outlook for RMBS (conforming) and auto ABS, for both of which obligor performance has long been stable, even during times of stressed.

Asset classes with a Negative outlook for underlying asset/collateral performance are due mainly to the severe business environment for Japanese corporates (ABS-SME Lease, CDOs) or the weakening real estate market (ABS-Real Estate Backed SME Loans, CMBS).

Since new issues with ratings published by Moody's and other rating agencies totaled roughly Y5.8trn in 2008, Moody's estimates that Japan's securitisation market may amount to roughly Y6trn. Thus, the structured finance market in 2008 shrank considerably, from Y9trn the previous year, due to the decline in issue amounts across all sectors.

In the report, Moody's also states rating implications for its rated securities based on the respective collateral performance Outlooks and the structural features of the asset classes.

Mortgage credit risk assessment in demand
A lack of trust in traditional ratings has prompted a soar in demand for external granular credit risk assessment for RMBS portfolios, according to Exact. The firm has carried out due diligence on over 20,000 borrowers and £2.5bn worth of mortgage assets since the launch of its Asset Quality Assessment (AQA) service in April 2008.

The Exact team has now completed due diligence for four major investment banks and hedge funds since introducing AQA. The need for transparency and a clear understanding of the risk and value of mortgage assets is critical, it says - particularly in light of the new UK government guarantee scheme.

SF CDOs on review
Fitch has placed 187 tranches (179 public ratings and eight private ratings) from 33 structured finance CDOs in Europe on rating watch negative. Twenty three additional tranches from eight transactions - which were previously on RWN - have been placed on rating watch review. In addition, Fitch has affirmed 17 classes of notes from eight transactions and downgraded two classes from one transaction.

These actions follow the publication of the agency's rating criteria for SF CDOs in December 2008. The revised criteria contain updated default probabilities, increased correlation assumptions and recovery rate assumptions that are based on tranche thickness. The correlation framework has been calibrated so that CDO notes rated in the high investment-grade categories can accommodate estimated peak default potential for portfolios of SF assets concentrated in terms of geography, sector and vintage.

In terms of expected rating migration as a result of the application of the revised SF CDO criteria, the majority of SF CDO notes currently rated triple-A are expected to remain investment grade. Notes currently rated double-A are expected to split evenly between low investment grade and high non-investment grade. Finally, notes currently rated single-A or below are likely to be downgraded to non-investment grade, with some being downgraded to single-B and below.

Fitch will begin resolving the rating watch within the next week. The criteria implementation process is expected to be completed by the end of the first quarter, with the majority of actions occurring in February.

CDS liquidity commentaries launched
Fitch Solutions has launched a new global liquidity commentary service, covering the top-five most liquid CDS corporate names in Europe, North America and Asia, as well as the top-five most liquid global sovereigns. Based upon the company's recently-launched Global Liquidity Scores, the commentary service provides bi-weekly information and a 'snapshot' commentary.

The service is designed to allow financial institutions to obtain independent information identifying the relative liquidity of each asset and its percentile ranking across the CDS universe. As a result, says Fitch, risk managers can compare the relative liquidity of assets across regions, sectors and rating bands, as well as information on the liquidity of an asset and the broader CDS market over time.

In general, the liquidity of a credit derivative asset increases when it is showing signs of financial stress in combination with a significant amount of debt outstanding and/or changes in its capital structure, including new issuance. The liquidity scores of assets have historically traded between four at the most liquid end, through to 29 at the least liquid end, according to Fitch.

The inaugural report indicates that in recent days South Korea has moved above Russia to become the most liquid sovereign CDS. Three South Korean banks are also in the top-five most liquid Asia-Pacific names - Korea Development Bank, Woori and Export Import Bank of Korea.

Meanwhile, Daimler and Volkswagen are both in the top-five most liquid names for Europe. GE, on the other hand, remains the most liquid traded CDS for the Americas; this is mainly due to recent market speculation that GE may lose its triple-A rating status because of funding concerns over its finance unit, GE Capital.

IDC beefs up evaluations services
Interactive Data Corp's pricing and reference data business now offers additional informational resources to complement its fixed income evaluations services. They are designed to help clients better understand IDC evaluations and the impact that daily market conditions may have on these evaluations. The resources are also aimed at helping clients prepare for their obligations under FAS 157.

As part of the service, IDC has introduced a daily market commentary that reflects activity in the US fixed income markets as of mid-day. Other informational resources now available to clients include: evaluations input reports; broker-quoted securities reports; and EVS documentation.

Evaluations input reports provide historical details on the market inputs for a selected sample of security evaluations and are designed to provide clients with additional information for their fair value hierarchy determinations under FAS 157. Broker-quoted securities reports compile a list of broker-quoted US corporate bonds, CMOs, ABS, CDOs and CMBS. Finally, EVS documentation enables clients to access a variety of evaluations-related documents via Interactive Data's desktop, including a FAS 157 position paper, summary of inputs by asset class and methodology documents that outline the evaluation process.

New sukuk issuance programme launched
Gatehouse Bank has established a US$1bn sukuk issuance programme dubbed Milestone Capital PCC. The unique structure of the programme allows for maximum flexibility with regard to the underlying Shariah structure used for each issue.

Gatehouse ceo David Testa comments: "We are very pleased with the success of the first issue under the programme. Given the strength of interest in the Milestone platform, we are currently considering increasing the programme limit significantly and look forward to using the programme to produce tailored financing solutions for our clients, from private placements to public, benchmark issues."

According to Gatehouse, the credit crunch has seen companies and investment firms turning increasingly towards the Islamic investor base for fresh and diversified sources of financing. The Milestone Capital platform provides a timely solution to finance and repackage Shariah-compliant assets, while giving investors access to these assets at transparent and attractive prices, the bank says.

Milestone Capital is a Jersey-based orphan protected cell company, designed to allow the efficient creation of new, segregated bankruptcy-remote cells. Each cell has the ability to issue a diverse range of sukuk certificates.

Ashurst was the legal advisor to Gatehouse Bank on the transaction.

Prime UK RMBS can withstand 30% house price decline
The impact of the continuing UK housing market downturn will have a minimal impact on the ratings of UK prime RMBS, says Fitch Ratings. The agency has examined the potential ratings impact of an expected 30% UK house price decline, from an October 2007 peak to the trough that Fitch expects in 2010, in a special report.

"With evidence increasingly pointing towards a UK recession of the magnitude last seen in the previous recession of the early 1990s, our analysis also factored in increasing defaults based on the performance of prime mortgages during that period," says Gregg Kohansky, md, EMEA RMBS at Fitch. "We found that under such stress, UK Prime RMBS ratings exhibit minimal negative rating transition."

S&P downgrades Japanese CSOs
S&P has downgraded 28 tranches relating to 22 Japanese synthetic CDOs as part of its regular monthly review of synthetic CDOs. The actions incorporate, among other things, the impact of rating migration and the auction results of ISDA.'s protocol being taken into consideration in the evaluation of Tribune.

The affected CSOs are: Andante Ltd.; Corsair (Jersey) No. 2 Ltd; Eirles Two Ltd.; ELM B.V.; Global portfolio CDO secured notes series 43; Elysium class B secured credit linked notes; Helium Capital Ltd.; J-Bear Funding Ltd.; Momentum CDO (Europe) Ltd.; SONATA notes; OPALE floating and fixed-rate credit linked notes; Omega Capital Investments; and Signum Vanguard Ltd.

CS & AC

Operations

The ECB raises the bar

Angus Duncan, partner at Cadwalader, Wickersham & Taft LLP, suggests that the scope of the ECB's new requirements for asset-backed securities to be repo eligible collateral may go further than intended

On 20 January 2009 the European Central Bank announced two new requirements that ABS must satisfy if a Eurozone bank or credit institution is to be able to use it as collateral for monetary operations, including one month and three month repo financing, with Eurozone central banks. The ECB described the changes as complementing the technical refinements of requirements that it had previously announced on 4 September 2008. However, the changes are not minor ones but are potentially significant for banks originating, structuring or investing in ABS.

The first new requirement is that, in order to be ECB eligible collateral, ABS issued on or after 1 March 2009 must be rated "AAA/Aaa" from an accepted external credit assessment institution (ECAI), at issuance. The second new requirement is that, in order to be ECB eligible collateral, ABS must be backed by a pool of underlying assets that does "not consist, in whole or in part, of tranches of other ABSs". However, ABS issued prior to 1 March 2009 will be exempt from this second requirement until 1 March 2010.

Requirement that ABS have a minimum rating of AAA/Aaa on issuance
The existing ECB criteria already require that ABS have a minimum rating of "A-/A3" in order to be ECB eligible collateral. The minimum rating of "AAA/Aaa" on issuance will be an additional requirement.

Although the wording of the press release is not entirely clear, in our view, based on the press release:

(1) ABS issued on or after 1 March 2009 and rated "AAA/Aaa" at issuance will remain ECB eligible collateral even if downgraded, provided that its rating is at least "A-/A3"; and
(2) ABS issued prior to 1 March 2009 does not need to have been rated "AAA/Aaa" at issuance in order to be ECB eligible collateral and is only subject to the already existing requirement that its rating be at least "A-/A3".

Impact of the requirement on already issued ABS
Investors currently holding ECB eligible ABS which was issued with a rating less than AAA/Aaa will not be affected by the new requirement. Similarly, originators which have already undertaken securitisations of assets in which the senior class of notes intended to be ECB eligible collateral was issued with a rating less than AAA/Aaa will not be affected.

However, originators will need to be conscious that if an existing securitisation is rolled over into a new securitisation the senior class of notes issued in the new securitisation issued on or after 1 March 2009 will need to be rated AAA/Aaa on issuance in order to be ECB eligible collateral. This requirement may encourage originators to prolong the maturity of existing securitisations, the senior class of notes of which is rated less than AAA/Aaa, by amending their terms to extend the revolving period or allow the pool of underlying assets to be replenished.

Impact of the requirement on future issuance of ABS
The ECB criteria have always provided that only the most senior class of ABS will be ECB eligible collateral. The capital structure of almost all ABS marketed to investors has included a senior class rated AAA/Aaa. The requirement that ABS have a AAA/Aaa rating on issuance will therefore affect those originators undertaking securitisations primarily for the purpose of creating ECB eligible collateral to use in repo transactions with Eurozone central banks rather than for marketing to investors.

In such securitisations the size of the most senior class of ABS, and thus the amount of ECB eligible collateral generated, is maximised by issuing the most senior class of ABS with a rating that is as near as possible to the minimum required rating of A/A3. If the most senior class of ABS is to have an initial rating of AAA/Aaa its size will have to be reduced so as to provide extra subordination.

The amount of ECB eligible collateral generated from underlying pools of assets will therefore reduce. This may make such securitisations and central bank repo financing less attractive relative to other sources of funding.

The ratings criteria for swap counterparties providing swaps for such securitisations are less onerous where the most senior class of notes is rated less than AAA/Aaa. Consequently, there are more potential counterparties for such swaps and the pricing offered by such potential counterparties may be more competitive. The requirement that the most senior class of notes be rated AAA/Aaa on issue may therefore make securitisations, which include swaps hedging payments received in respect of the underlying assets, more expensive.

Assessment of the merits of the requirement
The statement in the ECB press release of 20 January 2009 that the changes set out therein "aim at contributing to the restoration of a proper functioning of the ABS market" appears to be an oblique reference to the fact that over the past year European ABS issuance has become increasingly driven by the creation of ECB eligible collateral to be used by originators themselves for repo transactions with Eurozone central banks rather than by sales to third-party investors. The ECB may hope that the requirement that ABS issued on or after 1 March 2009 have a AAA/Aaa rating on issuance will encourage originators and arrangers of new ABS to structure it in order to attract interest from third-party investors rather than solely for the purpose of using the ABS as collateral for repo financing from Eurozone central banks.

The approach taken by the ECB in applying the requirement that ABS be rated "AAA/Aaa" on issue only to ABS issued on or after 1 March 2009 appears to have been motivated more by pragmatism than by principle. The ECB is trying to encourage new ABS issuance to be targeted at third-party investors without withdrawing the repo funding that it has already provided in return for existing ABS issued with ratings of less than "AAA/Aaa".

The ECB has also, sensibly in our view, provided that ABS issued with a AAA/Aaa rating on issuance remains ECB eligible collateral even if downgraded, provided it is rated at least "A-/A3". This allows Eurozone credit institution investors to be comfortable that a downgrade of such ABS below "AAA/Aaa" will not prevent them from using it as ECB eligible collateral (provided the rating remains at least "A-/A3").

Requirement that the underlying assets backing the ABS not themselves be ABS
The existing ECB criteria do not require that the underlying assets backing ABS be of any particular type or meet any particular requirements, other than that they not consist of credit-linked notes or similar claims resulting from the transfer of credit risk by means of credit derivatives. From 1 March 2009, the ECB criteria will require that the underlying assets backing ABS must not themselves be tranches of other ABS.

A number of possible motivations lie behind the ECB's introduction of the requirement:

(1) To prevent institutions acquiring portfolios of junior or mezzanine ABS at the discounted prices currently seen in the market and using those portfolios as underlying assets for ABS CDOs and CDO-squareds, which would have senior notes that would be ECB eligible and could be used to obtain senior funding from the ECB;
(2) To exclude ABS CDOs and CDO-squareds because of concerns about the complexity of the models used to rate such products and the value of the resulting rating; and
(3) To prevent the repackaging of non-euro-denominated ABS with a currency swap to create ECB eligible collateral.

Types of ABS affected by the requirement
The new requirement appears to us to affect, or at least potentially affect, principally three different types of ABS:

(1) CDOs which are backed by other CDOs, MBS or other ABS;
(2) ABS which are backed by mortgage loans, corporate loans or some other type of claim but where, for tax, regulatory or other reasons, the securitisation is structured so that some or all of such claims are held by an intermediate SPV which in turn issues securities to the SPV issuing the ABS; and
(3) repackaged ABS; i.e. where one or more ABS are transferred to an SPV, which issues new ABS backed by the ABS transferred and possibly also by currency and basis swaps entered into by the SPV.

Collateralised debt obligations
ABS CDOs and CDO-squareds, having as their underlying assets diverse pools of CDOs, MBS or other ABS issued by different issuers, clearly fail to meet the new requirement that ECB eligible ABS not be backed by underlying assets that are ABS. In addition, CDOs which have as their principal underlying assets high yield bonds or corporate loans, but which are permitted to, and do, hold some underlying assets that are ABS will fail to meet the new requirement.

The position is less clear in relation to CDOs that may according to their terms, but do not in fact, hold some underlying assets that are ABS. We are currently seeking clarification from the ECB on this point.

Asset-backed securities structured with a securities-issuing intermediate vehicle
The simplest structure for ABS involves a single SPV that acquires and holds the underlying assets and issues the ABS. However, also common are structures in which the SPV that issues the ABS is different from the SPV that acquires and holds some or all of the underlying assets.

In such two-SPV structures funding is provided from one SPV to the other by way of a loan or securities issuance. Reasons for these more complicated structures include tax and regulatory issues. In the case of such a structure and funding from one SPV to the other being provided by way of securities subscription, the securities issued by the asset-holding SPV to the ABS-issuing SPV are themselves ABS.

Consequently, the requirement that the underlying assets of ABS not themselves be tranches of other ABS might go so far as to prevent the ABS issued by such structures from being ECB eligible collateral. We are currently seeking clarification from the ECB on this point.

Repackaged ABS
In the context of the ECB collateral criteria, repackaging of ABS can facilitate the creation of ECB eligible collateral by allowing:

(1) ABS denominated in currencies other than euro to be converted into ABS denominated in euro; and
(2) ABS which is not the most senior class of ABS issued by the issuer thereof, and which as a result cannot constitute ECB eligible collateral, to be converted into ABS which is the most senior class of ABS issued by the repackaging vehicle.

The new requirement that ECB eligible ABS not be backed by underlying assets that are ABS will prevent repackaging being used for these two purposes. If a credit institution is holding non-euro-denominated loans, then it will remain possible for it to structure ABS with a currency swap so that the ABS issued is denominated in euro and potentially ECB eligible. However, if a credit institution is holding non-euro-denominated ABS, then it will not be possible for it to convert such non-euro-denominated ABS into euro-denominated ABS and use it as ECB eligible collateral.

Impact of the requirement on already issued ABS
The requirement that the underlying assets backing ABS not themselves be tranches of other ABS is not met by ABS CDOs and CDO-squareds, and any of these that are currently ECB eligible collateral will therefore cease to be ECB eligible collateral from 1 March 2010. We do not see any method of restructuring such assets to enable them to meet the requirement.

As regards other CDOs which have ABS as only a portion of their underlying assets, such ABS could be sold and, if necessary, the terms of the CDOs changed to prohibit future acquisition of ABS. However, as ECB eligibility is relevant only to the investors holding the most senior class of notes issued by such CDOs, such sale of ABS and changes of terms might be resisted by investors holding other classes of notes.

If the price that would be obtained for such ABS on a sale is less than the value at which it is currently being taken into account for the purposes of the CDO, then investors and the CDO manager may prefer not to sell such ABS. Investors and CDO managers will need to be mindful of the different considerations in negotiating any changes.

In the case of ABS structured with a securities-issuing intermediate SPV that issued securities to the SPV that issued the ABS, the consequences of the requirement that the underlying assets backing ABS not themselves be tranches of other ABS is unclear and depends on the clarification that the ECB is able to provide. In our view, the sensible position for the ECB to adopt would be one under which the requirement should be treated as satisfied provided even if the underlying assets of an ABS consist, in whole or in part, of other ABS provided that:

(i) such other ABS comprises all of the securities issued by the issuer thereof that are backed by a particular pool of underlying assets and not just some of, or a tranche or class of, such securities; and
(ii) the pool of underlying assets backing such other ABS does not itself include tranches of ABS.

If the ECB's position is that the requirement is not treated as satisfied in such cases, then there is a significant number of ABS which will cease to be ECB eligible collateral from 1 March 2010 and originators and investors will need to examine carefully transaction structures to see if the senior ABS issued by such structures is one of these. Restructuring such ABS to preserve ECB eligbility will be problematic because:

(i) in most cases the securities-issuing intermediate SPV will have been included in the structure in order to overcome a tax or regulatory issue and would not have been used if any alternative were available; and
(ii) the affected ABS is generally widely distributed, ECB eligibility is relevant only to the senior investors and junior ranking investors gain nothing by the restructuring and their co-operation may therefore be difficult to obtain.

Impact of the requirement on future issuance of ABS
The statement that simpler ABS structures are needed to attract investors back to the market has become almost a mantra of commentators over the past year or so. The ECB, by introducing the requirement that the underlying assets of ECB eligible ABS not include any ABS, is doing its bit to try to encourage simpler structures. The requirement makes it unattractive to include in CDOs of predominantly corporate loans or high yield bonds a bucket for ABS and we do not expect to see such buckets on new CDOs.

The requirement will impact on new CDOs of commercial real estate (CRE CDOs). The handful of European CRE CDOs undertaken to date have included as underlying assets junior ranking commercial mortgage loans or junior ranking CMBS or a mix of the two. CRE CDOs which have junior ranking CMBS as part of their underlying assets do not satisfy the requirement that the underlying assets of ECB eligible ABS not include any ABS.

On the other hand, CRE CDOs which have only junior ranking commercial mortgage loans as their underlying assets satisfy the requirement, as such junior ranking commercial mortgage loans are not ABS. Over time this is likely to encourage those structuring CMBS and CRE CDOs to create subordination outside of the CMBS transactions themselves by tranching the underlying commercial mortgage loans into senior and junior pieces.

Finally, the requirement will deter repackagings of ECB eligible senior ABS, as the repackaged ABS will not be ECB eligible collateral. This makes it more attractive to undertake within the ABS itself the structuring which would previously have been effected by the repackaging and therefore its effect may be to increase, rather than decrease, the complexity of securitisations.

Conclusions
The ECB's previous announcement of 4 September 2008 followed the regular review of risk control measures for Eurosystem credit operations which the ECB conducts every two years and had been anticipated for some time. However, there had for some time been a considerable amount of speculation that the ECB would increase the minimum rating requirement for ABS from "A-/A3" and there was some surprise when such an increase was not announced in the 4 September 2008 announcement.

The ECB has now increases the minimum rating requirement. However, originators and arrangers are relieved that it appears that ABS issued prior to 1 March 2009 is not affected by the increase and that ABS that is downgraded can remain ECB eligible collateral, provided it retains a rating of at least "A-/A3".

There is also relief that the ECB will continue to require ratings from only one external credit assessment institution (ECAI). By contrast, the Bank of England requires that ABS which is provided to it as repo collateral be rated by at least two rating agencies.

The ECB has also taken the opportunity to exclude from the scope of ECB eligible collateral ABS the underlying assets of which include tranches of other ABS. This exclusion will mean that the ECB will not have to accept as repo collateral ABS with highly complex cashflows and credit analysis, such as ABS CDOs and CDO-squareds, or certain ABS constructed primarily with a view to being used for repo transactions with Eurozone central banks.

However, as noted above, there is a risk that the scope of the exclusion is wider than is necessary and that it may prevent certain types of ABS from being used as repo collateral, even though they do not involve investment in tranches of other ABS and have market-typical structures. In particular, the exclusion may catch ABS which has a structure that involves one SPV holding the assets and issuing securities to another SPV that issues notes to investors. We recognise that it is not easy to distinguish between different types of transactions, but hope that the ECB will take the opportunity to clarify the position so that market uncertainty is avoided.

© 2009 Cadwalader, Wickersham & Taft LLP. All rights reserved. This article is adapted from a Clients and Friends Memorandum published by Cadwalader, Wickersham & Taft LLP on 21 January 2009.

Trading

Trading ideas: return to sender

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

Volatility in the credit and equity markets continues to create short-term opportunities to trade CDS against equity. A sharp movement in one market is not necessarily matched by the other.

This is the case with Pitney Bowes (PBI). The company's stock dropped more than 10% this week, but its CDS level barely budged.

With our directional credit model pointing towards stark deterioration in PBI CDS, we believe now is an excellent time to buy CDS protection and go long equity. Additionally, PBI's upcoming earnings announcement on 5 February should provide an additional catalyst for the two markets to reconnect.

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

After trading too wide for most of the autumn, PBI's CDS now trades well below our modeled fair value. PBI trades even farther below its expected level according to our directional credit (MFCI) model and an outright short on PBI by buying protection is a good directional trade.

Exhibit 2 charts PBI 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.

Exhibit 2

The red triangle indicates the current market values for CDS and equity. The red line is the modeled relationship between CDS and equity.

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 indicates a slight rise in the vol curve overall.

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 realized 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 PBI. PBI is a reasonably liquid name and CDS bid-offer spreads are around 10bp.

Buy US$10m notional Pitney Bowes Inc. 5-Year CDS at 115bp.

Buy 40,600 shares Pitney Bowes Inc. at US$22.10 to pay 115bp 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).