Contents

Correlation

The US$100bn question

Picking the winners from the losers in distressed mezz tranches

The distressed opportunity in mezzanine CSOs is believed to be worth several hundred billion dollars, but picking the winners from the losers is challenging. Sourcing the right asset remains key in tranche valuations.

The first step involved in valuing distressed mezzanine CSOs is to clarify what is meant by 'distressed', according to Loic Fery, managing partner of Chenavari Credit Partners (which has returned a 30% annualised performance on its AUM since last September). "We're not investing in a tranche because it's priced at 10 cents, but because it presents relative value compared to its price," he says. "To reach an appropriate bid level, we analyse how the deal's features will impact the price under various scenarios. Our primary goal is to source the right asset, then only to secure a good entry to the market."

Under this scenario, the structural features of the tranche (for example, attachment/detachment points), as well as the underlying collateral, should be well understood. A potential buyer should also have the ability to delve deeply into the documentation, particularly as most CSOs have been restructured.

Fery says that few funds have such expertise. "The market is extremely disintermediated and so there are only a very few buyers beyond the initial arranger that will want to bid on a given tranche. Consequently, the few buy-side players active in the sector are value-added to the holder of the position." Indeed, Chenavari's recent trades were a result of CSO holders approaching the firm directly.

Credit derivatives analysts at Morgan Stanley have analysed the portfolio characteristics of the 100 most common names (according to S&P) in bespoke mezzanine CDOs for clues as to expected default rates and hence subordination requirements. Almost a fifth of the portfolio is now rated below investment grade and sector composition is skewed heavily towards financials.

The analysts applied historical default rate experience for similar corporate portfolios (in terms of ratings distribution) and found that the worst-case five-year cumulative default rates for a similarly rated portfolio would be 8%-9%, nearly double that for CDX/iTraxx portfolios. This puts credit losses in the 5%-6% range, assuming a conservative recovery of 30%. While the experience of individual deals would vary, those with less than five years of residual maturity and subordination in excess of 6% could expect some recovery of principal.

The timing of subordination erosion also matters, according to the Morgan Stanley analysts. They calculate risk-adjusted IRRs for the portfolio in the range of 20%-50%, assuming the majority of the expected defaults in the five-year period occur in 2009 and 2010.

Furthermore, the analysts recommend dividing portfolios into three stratifications: wide trading names that are difficult to hedge and very binary; wide trading names where the outcomes are more skewed toward survival; and healthier names that are more default remote. "We believe that credits in the first camp should be 'written-off' in a worst-case analysis to determine how much subordination is left in the structure and that credits in the second camp are candidates for active hedging in any distressed mezzanine investment strategy," explains Sivan Mahadevan, global head of credit derivatives and structured credit strategy at Morgan Stanley.

He adds: "For the third camp, these are credits that should be left unhedged and represent the 'hope' of the investment strategy. Investors will find that some interest-only value tranches are timing plays on the wide end of this tail and that option-value plays are more a survival bet on the tail."

Some of the first movers into the distressed mezz CSO space have been hit by moving too early. Fery stresses the importance of managing risk appropriately: "Because we care about the position's NAV, we implement a variety of hedging strategies against mark-to-market volatility. We also can consider restructuring a position we buy in order to strengthen the tranche relative value," he says.

Indeed, understanding the dynamics of the tail names in particular in a portfolio is of utmost importance for profiting from the distressed mezz CSO opportunity. Mahadevan says that valuation is ultimately based on the level of stress in the underlying portfolios, while the collateral and unfunded tranche should be thought of in a first-to-default framework.

CS

CDS

Avoiding landmines

Profiting from the CDS index skew

The CDS index skew is expected to remain negative (indices trading tighter to their single name CDS constituents) in the coming months as the technical impact of credit deleveraging continues to be felt in the market. However, investors should be cautious about arbitraging the opportunity by selling single name protection against the indices.

Jochen Felsenheimer, co-head of credit at Assenagon, says that the skew is not an anomaly in the current market environment. "The skew in the CDS market is a function of spread dispersion (the spread difference between single name CDS in the index). The bigger the single name spread dispersion, the more attractive the index is versus single names and the bigger the (negative) skew," he notes.

Among the factors affecting the skew is the fact that current hedging activity is predominantly name-specific, that single names of a specific sector can gap out harder than the overall index and any CSO unwinds can result in large volume protection buying in single names.

One implication of the very negative skew is that it makes selling single name protection against the index an apparently attractive arbitrage, particularly as the traditional players in the space - hedge funds - have largely disappeared. For example, it may be possible to achieve tens of basis points of spread pick-up by buying protection in iTraxx Crossover and selling protection in its 50 single name constituents.

However, RBS structured credit strategist Gregorios Venizelos warns that selling single name protection entails significant gap risk, due to individual spread blow-outs (which tend to have a muffled effect within an index context). "In that respect, the skew arb trade is not a slam dunk by any means and, in addition, lack of liquidity in the single name CDS market means that the single name bid/offer spread can be quite punitive."

Felsenheimer agrees that illiquidity in the single name CDS market should not be underestimated. "The tradable skew is definitely lower (less negative) than the theoretical one."

Indeed, Venizelos suggests that a wiser relative value strategy would be to short the risk of single name CDS that an investor does not like and go long risk the index, thereby looking to benefit from the upside potential of being short risk of any "landmine" credits that blow out.

The CDS minus cash basis, meanwhile, is expected to start narrowing from its very negative territory in the coming months as demand for single name protection begins to outweigh supply and improved conditions in money markets reduce funding costs. "We called a narrowing in the basis in October, but it has mostly gone sideways since then. The basic premise is that liquidity is improving and counterparty risk is decreasing, but how soon it will actually start to take a notable effect on the CDS/cash basis remains to be seen," explains Venizelos.

A number of investors are nonetheless looking to take advantage of the opportunity on a buy-and-hold non mark-to-market basis by, for example, taking exposure through structured notes that allow for the position to be accounted for on an accrual basis (see also SCI issue 115).

However, as Felsenheimer concludes: "Given the high uncertainty regarding the regulatory measures the EU and also the US will potentially implement [see separate News story], single name CDS is probably less attractive for real money accounts compared to index investments. From talking to many players, single name activity appears to be fairly low right now."

CS

Investors

Changing tack

Credit managers adapt in line with new market paradigm

Credit asset managers are adapting - or are going to have to adapt - their investment strategies and product offerings in order to survive in the new credit market paradigm, according to a new report from Fitch. While institutional investors are gradually returning to the credit markets (see separate News Analysis piece), future investment strategies will most likely focus on carry and recovery trades, and credit products will become more simple, transparent and unleveraged (SCI passim).

The infrastructure of credit asset managers is also going to have to change, according to the report's co-authors, Manuel Arrive, senior director in Fitch's fund and asset manager rating group, and Aymeric Poizot, head of Fitch's fund and asset manager rating group in Europe. They suggest that rising idiosyncratic default risk will call for the development of more intensive research, including an increasing role of fundamental research, as opposed to quantitative analysis and modelling, which may have prevailed in the past.

"Investors in credit can no longer rely on historic default and spread assumptions; they need to be able to look at what is on the horizon instead of investing with a rear mirror," says Arrive.

Investment flows from institutional investors, such as pension funds, insurance companies and endowments, are already present in the credit market, but at a measured pace. Specifically, pension funds are seeking to diversify their duration risk as part of their immunisation strategies.

Fitch expects that future investment strategies that will appeal to these investors will extract performance from carry (i.e. crystallising the yields of bonds carefully selected to minimise credit events, recovery in distressed debts, bank loans with restructuring and working out, or dispersion) or playing one name against another or a name against its sector, essentially in the investment grade space where the deleveraging has been across the board, irrespective of the intrinsic credit quality.

The use of credit derivatives is not being ruled out, but will serve - at least in the short term - predominantly for shorting and hedging, and no longer as a substitute for sourcing assets on the cash market or execution of complex trading strategies, given expectations of continuing basis volatility and absence of liquidity premium to capture. Furthermore, absent any centralisation of clearing, counterparty risk still makes investors and managers cautious, Fitch suggests.

The report's authors also indicate that total return strategies with more short-term investment horizons, including technical arbitrage, are not seen by investors and managers as a valuable investment proposition for the time being, as long as liquidity and spread volatility remain uncertain. "This could change abruptly, once it is felt that credit conditions are on the verge of bottoming out," they add.

"Overall, an institutionalisation of credit managers is in progress and has been accelerated with the crisis, as reflected by the growing importance of the infrastructure," note Arrive and Poizot.

"Credit managers will ultimately differentiate themselves through their capacity to create the right product for the institutional investor. The investor will also judge them on their credit selection skills, access to both primary and secondary markets, and their capability in pricing and valuation," continues Poizot.

However, changing strategies and investment products will not come to the rescue of all credit asset managers. According to Poizot, many managers are currently in survival mode and are trying to adjust or even rebuild their platform.

"We are not expecting substantial inflows of new money to enter the credit space in the short term, so in some cases we could see a number of credit managers closing down," he concludes.

AC

CDO

Royal Park assets/prices disclosed

Fortis, BNP Paribas and SFPI/FPIM (Société Fédérale de Participations et d'Investissement/Federale Participatie en Investeringsmaatschappij) have released details about the assets to be purchased by Royal Park Investments, the SPV set up to acquire €10.7bn of Fortis Bank's structured credit portfolio under the Protocole d'Accord of 10 October 2008 (see table below). However, uncertainty remains about whether this rewrite will go ahead, with both a shareholder adviser (Deminor) and Ping An (a 5% stakeholder) threatening to vote against the deal as it stands at the EGM on 12 February (pending more information from the Belgian government).

Under the revised agreement, the parties will split the funding of the SPV in three layers: a euro-denominated equity component, with Fortis providing 66%, SFPI/FPIM 24% and BNP Paribas 10%; subordinated debt in US and Australian dollars, and sterling, provided for 66% by Fortis, 24% by SFPI/FPIM and 10% by BNP Paribas; and US-denominated senior debt, 90% of which is provided by SFPI/FPIM via a €3bn loan, with BNP Paribas providing the remaining 10%.

The €3bn loan is conditional upon Fortis agreeing that it is not entitled to receive any repayment of principal from the SPV for so long as SFPI/FPIM has an exposure under that portion of the loan. Accordingly, under the envisaged structure, Fortis will - at least in the initial phase - not be entitled to any repayment of principal, as these amounts will be applied towards repayment of the loan.

The SPV funding structure equates to BNP Paribas taking a net 12% stake in Royal Park Investments - with Fortis Bank stumping up €6.5bn in return for a €5bn government guarantee. The revised agreement will also see BNP Paribas purchasing only 10% of Fortis Insurance Belgium for €550m, instead of its previous 75% for €5.5bn.

CS

CDS

CDS market stung by regulatory threats

The CDS market was hit by threats of further regulation from both sides of the Atlantic this week, as supervisory authorities seemingly become increasingly frustrated at the perceived lack of progress being made towards reform (despite the industry's various commitments to this goal - SCI passim). First up was US House Agriculture Committee Chairman Collin Peterson, who circulated a bill proposing to ban naked CDS positions; this was followed by EU Internal Markets Commissioner Charlie McCreevy, who indicated that a regulatory approach is needed in order to establish a European CDS central counterparty (CCP).

In an address given to the EU Committee on Economic and Monetary Affairs, McCreevy suggested that, unless the banking system is made to function properly, the other measures being taken by member states to stimulate their economies will not have the desired effect. He stressed that a number of proposals remain on the table where the EU now needs to "close the deal" before the end of the current Parliament.

These proposals include preventing rating agency conflicts of interest and making the prudential regulations on capital requirements "watertight". But McCreevy's comments on the necessity of a "regulatory approach" towards establishing a European CDS central counterparty was what got the industry's attention.

"I welcome proposals to address the issue of clearing of credit default swaps on a European CCP, pending a more complete review of the whole derivative area," he said. "I had hoped the industry would agree on the necessity to clear trades on EU entities on at least one CCP in the EU. However, at the last minute they pulled out of an agreement and now a regulatory approach is necessary."

He added: "CESR and the ECB both consider that clearing of CDS on a CCP in the EU is essential for financial stability and oversight. I would urge the parliament to support an amendment to give effect to this."

ISDA issued a swift response to McCreevy's call to add to existing regulation of CDS. The Association points out that the European Commission rejected industry commitments on central clearing, first made to regulators in June 2008 and repeated to the Commission in December 2008.

"The CDS industry is dedicated to its very clear and demonstrable commitment to centralised clearing for these products," says Eraj Shirvani, ISDA chairman and head of European credit at Credit Suisse. "The industry has been the first mover on this matter, pursuing industry agreement on central clearing for CDS as early as 2006 and making global regulatory commitments in mid-2008, while also delivering industry-wide clearing solutions for a range of OTC products."

He adds: "We continue to urge coordinated global dialogue with all concerned regulators as a matter of priority. We respectfully urge the European Commission to resume its dialogue with the industry."

Away from the issue of central clearing, McCreevy also stressed the importance of removing the "dead weight of underperforming assets" from banks' balance sheets in order to get them functioning properly once more. He noted that the most difficult issue is how to put a proper valuation on complex assets: "Whatever schemes are drawn up, then they should be structured in such a way that the taxpayer is not over exposed to the risk of further losses and that the State can benefit from any upswing in the value of the assets in the years ahead."

Meanwhile, the industry also responded to Peterson's suggested ban. According to analysts at Credit Derivatives Research (CDR), the draft legislation would, if passed, have disastrous results for the CDS market.

"This is a draconian regulatory oversight overreaching, which would basically crush the CDS market - whether on or off-exchange or through a CCP," notes Tim Backshall, chief credit derivatives strategist at CDR.

He adds that if Section 16 of the bill takes effect then repo costs will rise, carry costs will rise and therefore bond prices will drop (as spreads rise to cover this potential loss). He also notes that, should the CDS market become disenfranchised, then the cost of funding via the primary capital markets will rise even further as the ability to manage that risk for real money accounts will disappear.

"What do they think will happen to the cost of protecting (buying insurance), if the person selling it knows that the person buying it 'needs it'," Backshall asks. "Seems like a silly point, but if I have to be short the bond to sell you protection, then am I going to charge you a higher or lower premium on insurance?"

ISDA expressed its disapproval of the draft. "This bill would increase the cost and reduce the availability of essential risk management tools, while failing to address the true causes of the credit crisis," comments Shirvani.

He adds: "Throughout the crisis, credit default swaps have remained available and liquid. They have been the only means of hedging credit exposures or expressing a view at a critical time for the industry. Impairing their use would be counterproductive to efforts to return the credit markets to a healthy, functioning state."

Peterson has since reportedly said that the ban wouldn't be permanent and is meant to complement the restriction of short selling of equities imposed by the SEC.

Nonetheless, CDR joins other market participants in calling for politicians and mainstream media to be educated on the difference between single name CDS (which structured credit analysts point out remain highly liquid, transparent, settle practically and are operationally sound) and the bespoke CDO markets (which are the main cause of AIG's stress - among other players - and likely heavily populate the Level 3 assets of many banks and brokers).

CS & AC

CLOs

Euro CLOs fare better than US counterparts, but for how long?

The ever-increasing loan issuer defaults are visibly taking their toll on junior and mezzanine notes of CLOs. Although European CLO transactions have fared better than their US counterparts so far, structured credit analysts at Citi note that the speed of deterioration in collateral WARF (weighted average rating factor) and migration to triple-C indicates that European transactions may follow a similar path in coming months.

According to the latest trustee reports on Intex, the average WARF of collateral underlying US CLO deals jumped by almost 100 points to 2,585 in just two months, while the average triple-C basket size increased to close to 10%. The default rate in US CLOs has moved higher by 0.6% to 2%, though this number hardly includes any of the January or December defaults, point out the Citi analysts.

According to Citi's analysis of triggers, at least 11 transactions have been breaking their single-A overcollateralisation test, roughly 10% of transactions have been breaking their junior mezz OC tests, while roughly 30% of CLOs have been breaching their interest diversion test.

"With defaults and negative rating migration looming, we see further evidence that performance is likely to vary broadly across managers, though some of this dispersion may be explained by the fact that managers who so far have fared better than others have a higher-than-average exposure to names that could be teetering on the brink of default," they say.

AC

Trading

Illiquid asset platform to expand into CDOs

SecondMarket, an online marketplace for illiquid assets, is set to expand into CDOs, MBS and limited partnership interests in hedge funds, venture capital funds and private equity funds during Q109. The move comes as the face value of the securities traded on the platform surpassed the US$1bn mark, doubling since August 2008.

SecondMarket says it passed the US$100m threshold two-and-a-half years ago, while its first transaction was completed less than four years ago. "Given the dislocation of the financial markets, we're seeing incredible momentum," explains Barry Silbert, ceo of SecondMarket. "The rapid growth within our asset classes and our expansion into new asset classes are testaments to the need for a marketplace to buy and sell illiquid assets. And, given the strong demand we've seen in just the first few weeks of January, we expect substantial growth in trading volumes in 2009."

Through its free online trading platform, proprietary matching algorithm and deep network of contacts, SecondMarket says it is able to connect buyers and sellers in an efficient manner. There are no restrictions on who can sell through the platform or view research and market activity, but only qualified institutional buyers and accredited investors may bid on listed assets.

Currently, SecondMarket serves as the marketplace for auction-rate securities, bankruptcy claims and illiquid blocks and restricted securities in public companies. "There are a significant amount of illiquid assets that are creating a drag on financial institutions around the world," Silbert adds. "SecondMarket is providing the centralised, independent and transparent marketplace necessary to provide price discovery and trading activity for these assets."

CS

CDS

Derivatives are a zero-sum game: true or false?

Anu Munshi, partner at B&B Structured Finance, explains that it is necessary to look at the cash underlying in order to find out what's been happening in the derivatives market

Derivatives are bilateral contracts, so one party's loss is equal to its counterparty's gain and therefore the transaction as a whole is a zero-sum game. Right? Well, if that's true, then why has almost everyone who has traded derivatives lost money over the last year?

It's because derivatives are only a part of any market. We need to look at the entire market to understand what's been happening. The devil, surprisingly, is in the cash instruments.

Let's look to credit derivatives as an example. If Bank A buys protection and Bank E sells protection on Daimler AG, and Daimler AG files for bankruptcy, then Bank A will make as much money as Bank E will lose on the CDS contract. If Bank A buys protection from Bank B, who buys protection from Bank C, etc. with Bank E as the ultimate seller of protection, the chain of transactions will still amount to a zero-sum game. Bank A will make as much as Bank E loses and the other banks' offsetting positions will net to zero.

The fact is that, with the exception of a few hedge funds, most investors don't buy protection outright. They either buy and sell back-to-back protection in the business of making markets or they buy protection to hedge their credit risk, which is typically in the form of cash bonds or loans (and sometimes in the form of counterparty risk).

So, if Bank A buys protection to hedge a loan it has made to Daimler AG, then it doesn't make money when Daimler AG files for bankruptcy - its gain on the CDS is offset by its loss on the loan. So the party losing in this example is Bank E.

In this instance, the economics in the chain of CDS still amount to zero, but because we've added a loan to the chain the overall economics no longer net to zero. At the end of the chain, Bank E loses money because it has taken on credit risk to Daimler AG.

So who wins? Daimler AG, at the start of the chain, because it has borrowed money and doesn't have to pay it back.

We've got a borrower at the start of the chain and a lender at the end of the chain, and a bunch of CDS trades in the middle that net to zero. There are, of course, some CDS contracts where investors have bought protection outright.

Those investors have made money at the expense of their counterparties, but they're a small proportion of the overall credit market. The majority of trades have been end-investors who took on credit risk and lost money when those credits deteriorated.

In the end, CDS is just a tool. The tool has worked as it should. The house is just not standing any more.

Technology

One-stop valuation shop

David Pagliaro, EMEA commercial director, ABSXchange and Peter Jones, global head, Valuation Scenario Services (VSS), Standard & Poor's answer SCI's questions

David Pagliaro

Since then, S&P has improved the product offering to increase the appeal for trading and research functions, buy-side portfolio managers and regulators. Today, ABSXchange continues to evolve into S&P's one-stop structured finance platform, providing three central services to the structured credit markets - data retrieval, cashflow analysis and portfolio monitoring.

PJ: Both the structured finance platform and the valuations business form part of S&P's Fixed Income and Risk Management Services (FIRMS), which launched in 2008. S&P has been offering an evaluations service since the 1970s, covering over 2.9 million daily evaluated prices.

Over the past 10 years more than 1.1 million US structured instruments have subsequently been added and in 2005 European ABS capabilities were added. However, the new valuations service - which we launched in January - adds additional and new capabilities to the FIRMS suite of valuations capabilities.

Valuation Scenario Services, as the new business is called, brings together several offerings from within S&P's FIRMS division to provide a number of different analytic and model-driven valuation solutions for a broad range of illiquid and complex asset classes. We hope that the new valuation service will meet today's significant industry requirements not only for transparent delivery of valuations but also, even more crucially, for the methodologies and assumptions used to produce them.

Q: How do the services distinguish themselves from the credit rating side of the business?
PJ: The two businesses operate independently of each other and address very different analytical issues. The credit ratings business is focused on producing opinions about the probability of default for bonds, including structured finance transactions. The role of VSS is to help investors value illiquid and complex assets.

While the two businesses may often examine the very same deal, it is from entirely different standpoints. We have strict firewalls in place to preserve the independence and objectivity of each analytic process.

In some cases, as with ABSXchange, FIRMS acts as a technology provider to the ratings business as well as to the valuation businesses, while the valuations services and the ratings business themselves operate independently.

Q: How has the service of the two platforms/offerings developed since they were first launched?
DP: Since acquiring the structured finance platform in 2007, S&P has made significant investments in cashflow modelling, data operations and in its IT resources. Consequently, ABSXchange has evolved into a single platform that can be used across the structured finance market - from the structuring phase of a transaction to research and trading, and to portfolio management.

At the moment, users of the structured finance platform have unrestricted access to data and analytical tools for more than 2,500 European structured finance deals. This number continues to grow as we add more deals in Europe and extend the reach of the service to Asia, Australia and the US.

While we have ongoing performance data for most of the European universe, over 80% of European RMBS and CMBS transactions are modelled on the platform, and this coverage is increasing every day as our modelling team continues to build out our library. We are also working with issuers to increase delivery of asset level data via our platform - something we already do for most CMBS deals and a large proportion of RMBS deals.

PJ: The launch of VSS represented a natural development within the FIRMS division by bringing together the core capabilities of the structured finance platform with FIRMS' other structured finance functionalities, content sets and universes. We are now offering our clients customised reporting and bespoke valuation for all their hard-to-value structured finance assets, drawing on many products and services already at our disposal.

Q: Which market constituent is your main client base? Do you expect this to change over the coming year - and why?
DP: ABSXchange is fast becoming a benchmark for the industry, across the buy-side and the sell-side, as well as for regulators. Examples of clients from these segments include Barclays Capital European Securitisation Research, M&G Investments, Credit Foncier and the UK's Financial Services Authority.

For several reasons, demand is increasing most rapidly from buy-side institutions. Investors holding illiquid structured finance assets are using the platform to analyse robust cashflow models that calculate returns given particular anticipated scenarios.

Portfolio managers and analysts also use the application for portfolio surveillance. And recently funds looking to buy up distressed debt and illiquid assets have started using the platform to help inform their trading activity.

PJ: FIRMS is currently working with a number of banks, industry and regulatory bodies, as well as traditional investors, to help them with the valuation of complex and illiquid securities. Indeed, VSS is intended to be an effective support for institutional investors to meet today's new regulatory accounting requirements, and to show transparent operational and risk management processes as delineated by IFRS 7, the Bank for International Settlements and the FSA. As such, VSS's main client base at the moment includes insurance companies, banks and funds.

Q: What are the main drivers behind clients approaching you?
DP: EMEA market participants are concerned about improving their internal systems for risk management. While organisations will likely decrease overall IT spend this year, investments in systems for risk management will take priority as integrated risk becomes increasingly important in today's markets.

Indeed, banks, asset managers, insurance companies and alternative investment managers are all actively looking to improve their risk management systems. ABSXchange directly responds to this need by providing unparalleled transparency through its data and sophisticated analytical tools.

PJ: At the moment, there is a lot of focus from the industry supervisory bodies and regulators on the issue of valuation and clients are approaching us to help them address such internal and external requirements for transparency around their valuation process. Indeed, the availability of data, analytics, cashflows and valuations are all key to injecting greater transparency into the industry - from meeting supervisory requirements through to aiding the investment process.

The Bank for International Settlements, the UK Financial Services Authority and SIFMA have all recently issued reports highlighting the increased importance of risk management and the oversight of an institution's valuation processes. These processes require many different types of valuation output from institutions and VSS is certainly helping institutions to meet those demands.

Q: Which asset classes do you currently focus on and into which areas are you looking to expand?
DP: The structured finance platform has been used to model US, European and Australian structured transactions. In Europe, we have exceptional coverage of UK prime RMBS master trusts, UK non-conforming RMBS, continental European prime RMBS, CMBS and consumer ABS. Our deal library is the largest in Europe today, and we are currently expanding it to cover European CLOs and asset classes from other regions.

PJ: The VSS business is focused on the delivery of these structured finance assets at the moment, principally in the US and Europe, but we are building out the service and modelling deals on custom request to ultimately cover any illiquid and complex securities that are subject to valuation requirements requested by clients.

Q: Which asset classes are you currently seeing most interest in from your clients and why?
PJ: Most of the interest at the moment is in UK RMBS, including all of the master trusts. There is also, naturally, a lot of attention around US sub-prime RMBS and European CLOs.

The UK RMBS market is one of the largest sectors in terms of the amount of assets outstanding in Europe. And, with recent events with the Granite master trust triggers and focus on the collateral performance in the non-conforming loan sectors, clients are naturally focusing on surveillance of the performance of these assets and the impact of changes that their assumptions are having on valuations.

Q: How do you differentiate yourself from your competitors? Who do you consider to be your competitors?
DP: ABSXchange is positioned at the centre of the structured credit market as the primary provider of deal data and analytics for market professionals of all orientations. As such, the service aims to be the benchmark provider in Europe, meeting the needs of arrangers, issuers, investors, regulators and all other market participants. We try and achieve this by focusing on data integrity and by delivering robust, deal-specific cashflow models and sophisticated analytical tools, such as portfolio monitoring and break-even analysis.

ABSXchange also has a dedicated team of analytical client support resources in the region which works hand in hand with our clients. And, unlike our competitors, ABSXchange is entirely dedicated to the European market.

PJ: There are a number of niche players in the market and elements of offerings from some specialist software providers providing similar IT solutions. But what is unique to us is the depth and breadth of the service we offer - the scale and market expertise that we provide, combined with the fact that our services are already being delivered to clients. Although there are competitors offering the software or the data, there are none capable of providing the data, analytics and cashflow models in combination with the valuation tools and deep market expertise we have within FIRMS.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
PJ: Nearly all financial institutions in today's environment are affected by the requirement to generate new revenues while attempting to control costs and address the risk management issues presented by the current market environment. This presents an opportunity to FIRMS, one we have already started to address with the launch of Valuation Scenario Services.

The current environment has also enabled us to draw on a range of skill-sets already within the business to create new products and drive new revenue streams. It also allows us to better scale our business according to client requirements.

Q: What major developments do you need/expect from the market in the future?
DP: The market is still dealing with a sizeable "hang over" in terms of primary market issuance from 2007, as well as actual and perceived performance issues that surfaced during late 2007 and 2008. Some market participants will continue to exit the market, although at a slower pace than they did last year, while many others will either do nothing or act opportunistically.

Indeed, there remains sufficient existing issuance in the market to satisfy the needs of active participants. However, for any organisation that remains in the market, there is a clear advantage to engaging with services such as ABSXchange and VSS to track and carry out surveillance of their portfolio performance and ensure greater confidence in investment decisions.

PJ: We will certainly see increasing demand for greater transparency of all kinds. For example, for loan level data and cashflows based on greater underlying collateral analysis - exactly the kind of data and functionality sourced from our structured finance platform. It is also clear we will see an ever increasing focus on the input assumptions going into valuations across all illiquid and complex structured finance asset classes.

We believe that one of the major developments taking place today, and for the foreseeable future, will be the creation of a set of standards around valuation. The market needs to form consensus around all the input assumptions, models and processes involved in valuation and the FIRMS structured finance offering has positioned its capabilities to help clients and the market to address these developments.

Aladdin expands brokerage operations ...

The latest company and people moves

Aladdin expands brokerage operations ...
Aladdin is building its broker-dealer presence in the UK and the US, and has hired two securitisation experts: one to head up securitised products and another as md for broker-dealer sales and marketing.

Aladdin announced in January that it was restructuring its business in order to pursue new opportunities in the marketplace (see SCI issue 120).

Joining Aladdin as global head of securitised products is John Carroll, who was previously head of global securitised asset trading at Barclays Capital. David Attisani joins Aladdin as md, broker-dealer sales and marketing. He was previously vp MBS/ABS sales at Countrywide Securities. Both Carroll and Attisani will be based in the US, with Carroll overseeing sales and trading staff both in London and in Stamford.

... while equity broker moves into ABS/MBS
BTIG, an institutional broker dealer specialising in equity trading and related brokerage services, has launched a fixed income group. The team will be focused on sales and trading of credit products, which will cover the full credit spectrum from investment grade to distressed debt. In addition, BTIG will be creating a new team to expand into ABS/MBS trading.

The expansion into credit trading will add a further 60 employees to the firm's global headcount. To lead the fixed income team, BTIG has hired Jon Bass and John Purcell as co-heads of global fixed income.

Bass joins BTIG from UBS, where he was most recently head of fixed income client management. Purcell was previously at Citigroup, where he held a variety of fixed income positions and was most recently head of global fixed income syndicate and North America capital markets (see separate News Analysis article for more on the rise of brokers in the structured finance space).

Permacap adjusts assumptions, establishes reserve
Tetragon Financial Group (TFG) has changed its IRR modelling assumptions, in line with a marked deterioration in economic outlook, and established a balance sheet reserve against potential unrealised losses arising from rating agency downgrades to its investments' underlying collateral.

The vehicle's assumed constant annual default rate has been increased to approximately 6.4%, which is 3x the original base-case WARF-implied default rate, for the next three years, followed by a return to 1x (the original base-case WARF-implied default level) thereafter until maturity. Assumed recovery rates have been adjusted to approximately 55% (or approximately 0.8x of the original base-case assumed weighted-average recovery rate) for the next three years, followed by a return to 71% (the original base-case recovery rate) thereafter until maturity.

Assumed loan prepayments have been reduced to7.5% per annum for the next three years, followed by a return to 20% (the original base-case prepayment rate) thereafter until maturity. A 0% prepayment rate on bonds throughout the life of the transaction, as in the original base-case assumptions, has also been assumed.

Finally, the assumed reinvestment price has been reduced to 87%, a level that generates an effective spread over Libor of approximately 735bp on broadly US syndicated loans, 745bp on European loans and 805bp on middle market loans for the next three years, followed by a return to par reinvestment price (the original base case reinvestment price) thereafter until maturity.

The net effect of these changes for the vehicle's December 2008 month-end results was to reduce the weighted-average IRR by approximately 2% and the estimated fair value of TFG's investments by approximately US$59m, in each case relative to the immediately preceding assumptions utilised. Consequently, the weighted-average IRR ended the fourth quarter at 13.8%, compared to 16.1% for November 2008.

The investment manager believes that negative loan migration, specifically migration to Caa1/CCC+ or below, may place pressure on the performance of certain of TFG's investments. Caa1/CCC+ or below rated asset exposure over pre-defined limits in such investments may temporarily cause cash diversion away from CLO equity tranches and into the reinvestment of new collateral and, if significant enough, potential deleveraging of the CLO.

The vehicle's new accelerated loss reserve seeks to address the impact this risk and other potential unrealised losses may have on the fair value of TFG's investments. For the quarter ending 31 December 2008, the reserve totaled approximately US$141m.

MBS trader hired
Roger Ashworth has become the latest member of Amherst Securities. He has joined as an RMBS research analyst, coming from Merrill Lynch, where he was an MBS trader. Broker-dealer Amherst have hired a number of new people across the company (SCI passim) and is understood to be looking to increase its headcount this year.

New role for structured credit head
HSBC has appointed Matthew Cannon as md, treasurer and head of global markets, Korea. Cannon was previously head of structured credit products, Asia Pacific, at the bank.

CRE mezzanine platform expands
Prudential Real Estate Investors (PREI) has hired a team of real estate finance veterans to build a commercial real estate mezzanine platform in Europe. PREI has absorbed the team at Paramount Private Equity, founded by Andrew Radkiewicz and Andrew Macland, who formerly headed the real estate finance business at N M Rothschild & Sons in London.

The Paramount fund platform focused on originating, structuring and managing debt and mezzanine investments in the European real estate markets. Radkiewicz and Macland, both mds, are being joined by Mathew Crowther and Brian Scally.

"Changes in the real estate and banking markets have created opportunities for our investors," comments Robert Falzon, md and head of PREI's European business. "This London-based team has the skill to identify opportunities, the capacity to accurately assess risk and the judgment to make the right choices for our clients. With the experience of more than £3bn in transactions, this team perfectly complements our successful US mezzanine strategy."

Securitisation heads appointed
Société Générale has appointed Jim Ahern and Marc Nocart as joint global heads of securitisation within the fixed income, currencies and commodities (FICC) division. Ahern is based in New York and retains his role as head of capital market finance for the Americas. Nocart is based in Paris and was previously co-head of securitisation for Europe.

They both report to David Coxon, global head of capital markets finance and his recently appointed deputy Antoine Bostsarron. Ahern also reports locally to Liz Hogan and Jérôme Jacques, who head the FICC division for the Americas.

Codefarm and Calypso join forces
According to industry sources, the team of Codefarm and its portfolio structuring and management platform Galapagos are now part of Calypso. It is anticipated that Codefarm customers and partners will benefit from this development that will enable Codefarm to widen the scope of Galapagos, leveraging Calypso's broad cross-asset trading platform, which will provide access to any asset class in any market.

CDO AM ratings downgraded, withdrawn
Fitch has downgraded Solent Capital Group's CDO Asset Manager rating to CAM3+ from CAM2 for investment grade corporates and affirmed the CAM3 rating for structured finance. Both ratings have been withdrawn and Fitch will no longer provide rating or analytical coverage on Solent Capital's IG corporate or SF CDO asset management activities.

Overall, the rating actions reflect the adverse impact and ongoing pressure on Solent's business franchise as a result of the continued credit market turmoil, says Fitch. "Given the decline in the organisation's assets under management by over 30% in 2008 and the lack of institutional support, Fitch views that the business and financial viability of the company over the medium term is conditional on its ability to attract assets and diversify revenues for continued profitability," the agency says. "However, the ratings also acknowledge the swift management actions in response to deteriorating markets to reduce staff by about 25% in late-2007, which helped the company increase profitability in 2008."

In addition, Fitch notes that some of the new business initiatives are showing tentative signs of fruition.

Law firm adds two
Walkers has made two appointments in its London office. Linda Martin moves over from Maples and Calder to become new head of finance and corporate for London and the Middle East. She brings expertise in a wide range of debt and equity capital markets transactions, including structured finance, asset financing and general banking and corporate matters. Chinyin Lim will join the finance group as an associate, moving over from the financial structuring group at Linklaters.

Consortium bids for LCH.Clearnet
LCH.Clearnet has confirmed that it has received a preliminary approach about an offer for LCH.Clearnet from a consortium of banks and other financial institutions. According to a statement from the firm on 2 February, LCH.Clearnet had not received any offer. It says that LCH.Clearnet's discussions and due diligence with DTCC continue in regards to its merger announced last year.

According to press reports, the consortium that has approached LCH.Clearnet includes BNP Paribas, Citigroup, Deutsche Bank, HSBC, JPMorgan, RBS, Société Générale and UBS. Inter-dealer broker ICAP has also confirmed its interest in the clearer.

AC & CS

Upside for FFELP student loan ABS

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

Upside for FFELP student loan ABS
Structured finance analysts at JPMorgan note that FFELP student loan ABS has the most potential for upside, given the proposed stimulus bill currently going through Congress. The bill includes an amendment to the Higher Education Act that aims to fix the CP/Libor basis by changing the FFELP subsidy index to three-month Libor minus 13bp instead of 90-day CP. The Department of Education has also completed work on a proposed ABCP conduit facility for FFELP loans that will provide back-stop liquidity to the ABCP, buying loans from the conduit only in the event that the market cannot roll.

"There remains over 200bp pick-up in FFELP student loan ABS over comparable agency paper; an exceptional relative value," the analysts argue. "In addition, the FFELP lending industry has benefited from the fastest and most decisive government actions, in comparison to banks and automakers."

FFELP student loan ABS tightened by 50bp across the structure with three-, five- and 10-year paper at 250bp, 260bp and 275bp respectively. The term curve has flattened since the beginning of the year: the three- versus 10-year spread differential is now 25bp compared to 75bp.

UK Asset Purchase Facility outlined
Further details of the UK government's Asset Purchase Facility were outlined last week by Chancellor Alistair Darling and Bank of England governor Mervyn King. The UK government is to direct the Bank of England to purchase up to £50bn of high quality private sector assets, which will initially include paper issued under the Credit Guarantee Scheme, corporate bonds and commercial paper. At the same time, the BoE will consult with market participants about plans to purchase syndicated loans and ABS created in viable securitisation structures.

Details of the mechanisms through which the Bank of England plans to conduct its initial asset purchases are expected to be announced this week. King says he expects the amount of assets purchased to increase gradually in the early stages of the facility in order to assess the impact of those purchases on market liquidity. A new company is being established to undertake the transactions, which King says will provide a clear, transparent mechanism for monitoring the operations conducted under the facility.

Basel 2 changes to impact senior CLO capital efficiency ...
Enhancements to the Basel II framework, which include a move to increase the risk weights that banks would use when calculating capital allocations against holdings that qualify as resecuritisations (see SCI issue 120), will have only a moderate effect on the overall capital efficiency of senior CLO tranches as far as banks are concerned, according to structured credit strategists at Barclays Capital.

"We believe that the proposed increases in risk weights, if implemented in their current form, will have only a moderate effect on the overall capital efficiency of senior CLO tranches as far as banks are concerned," say the BarCap strategists.
CLO tranches that do not hold securitised assets will not qualify as resecuritisations, so the proposed changes to risk weights would have no effect.

However, many CLO transactions would qualify as resecuritisations because of their holdings of other securitisations (e.g. tranches of other CLOs). BarCap estimates that about 44% of such CLO trades are currently outstanding.

"For these CLO transactions, the effect of the changes in risk weights will depend on a number of different factors, including the current regulatory framework that banks are operating under; the rating of the tranche; and whether or not the exposure is being held in a negative basis book and insured through another counterparty."

... while CLO weakness may increase refinancing risk
S&P has released a research note explaining that extended weakness in the CLO market may exacerbate refinancing risk for speculative-grade US corporations. The agency argues that a considerable portion of corporate borrowing, which in recent years had been handled outside the traditional banking system through the 'originate and distribute' business model employed by many banks, is now reverting back to banks' balance sheets with unprecedented speed. As these financing sources have become considerably scarce, many already financially-challenged US corporations are now facing the increasingly daunting prospect of refinancing their borrowings.

"It's entirely possible that corporations could refinance their future borrowings without using structured finance techniques," says the rating agency. "Nevertheless, it's neither feasible (without significant governmental intervention) nor desirable for many market participants to abruptly wind down their entire amount of outstanding structured finance debt instruments. Because a significant amount of these debt instruments have relatively long maturities, we believe it is useful for us to continue to examine these existing structures (and structured financing techniques in general) and their potential impact on future corporate borrowings."

Benchmark to measure impact of TALF?
The recent closing of the US$1.3bn HAROT (Honda Auto Recievables Owner Trust) 2009-1 provides a useful benchmark to measure the impact of TALF on the ABS market, according to structured finance analysts at Wachovia Capital Markets. The difference in spread between TALF ineligible and eligible deals will give a measure of the subsidy being provided, they say.

It is anticipated that pricing spreads on new TALF ABS deals will be tighter than they would be without TALF funding. Investors who can take advantage of the leverage available from TALF would benefit from the subsidy disproportionately compared to cash investors because they may be able to accept lower credit spreads, while boosting returns through leverage.

"We believe that TALF will boost new issue activity, but it will likely come at the expense of traditional cash ABS investors who will find it more expensive to provide liquidity to issuers," the analysts note.

HAROT 09-1's two-year triple-As priced at 375bp over swaps - 50bp more than generic two-year triple-A prime auto spreads, which is unusual for such a benchmark issue. The deal isn't TALF eligible because the collateral is too seasoned.

Lyondell CDS/LCDS auction prices determined
Creditex and Markit, in partnership with credit derivative dealers, have announced the results of the credit event auctions conducted to facilitate settlement of credit derivative trades referencing three subsidiaries of LyondellBasell Industries: Lyondell Chemical Company, Equistar Chemicals and Millennium America. The final prices were determined as follows: 15.5% for Lyondell Chemical CDS; 20.75% for Lyondell Chemical LCDS; 27.5% for Equistar Chemicals CDS; and 7.125% for Millennium America CDS.

Monoline hit by distressed exchange criteria change
S&P has lowered its issuer credit and financial strength ratings on Syncora Guarantee to double-C from single-B. At the same time, these ratings were removed from credit watch with developing implications. The outlook is negative.

The downgrade is the result of S&P's recent update to its distressed exchange criteria, including the commutation of CDS by bond insurers. Once a distressed offer or commutation is announced or otherwise anticipated, the agency will lower the issuer credit and financial strength ratings to reflect the risk of non-payment under a financial guarantee policy.

S&P says it generally lowers the ratings to double-C and assigns a negative outlook, reflecting the possible 'SD' issuer credit rating upon completion of the commutation. After the commutation is complete, the agency could raise the rating if management presents a reasonably viable strategy to strengthen the company's financial positions and protect policyholders.

Syncora has entered into an agreement with 17 bank counterparties to commute, terminate, amend or restructure existing CDS and financial guarantee contracts. S&P has taken into consideration the company's lack of meaningful advancement on the restructuring and slow progress in its negotiations with counterparties of its ABS CDO exposure.

For the quarter ended 30 September 2008, the New York Insurance Department (NYID) granted Syncora permission to release statutory basis contingency reserves on terminated polices and on policies on which the company had established case reserves. As a result, the company reported policyholders' surplus of US$83.3m. Absent the release of contingency reserves, Syncora would have reported policyholders' surplus of US$19.1m, well below the US$65m minimum.

If Syncora experiences further adverse loss development on its ABS CDOs or on its 2005-2007 vintage RMBS exposure, the company could fall below the NYID minimum surplus requirement. It is unclear if the NYID would grant an additional release of contingency reserves to bolster surplus.

SIFMA CDO volumes down
Total quarterly CDO issuance volume in Q408 dropped by 61% compared to Q308 (which had already seen a 46% decline from the second quarter), according to the latest SIFMA figures. Total issuance in 2008 was 87% below the volume in 2007.

The SIFMA data accounts for public cashflow and funded synthetic and hybrid transactions only.

Balance sheet issuance rose on the quarter, although it accounts for below 40% of volume. Structured credit analysts at UniCredit are surprised by this figure, given that CDOs (and ABS in general) are still primarily structured as collateral for central bank lending facilities.

Almost half of the CDOs issued (49%) have high yield loans as collateral, according to SIFMA, resembling the situation during the first three quarters of 2008 and reflecting the fact that banks continue to deleverage their balance sheets. The fraction of investment grade CDOs was small at 15% (an absolute volume of only US$755m). With a volume of nearly US$1.8bn, structured credit CDOs contributed the remaining 36% of issuance.

The total issuance of US$5bn in Q4 is record-breaking, according to UniCredit, with 47% being euro-denominated transactions and only 18% in USD. An unprecedented fraction of 29% was issued in currencies other than euro, dollar, yen and sterling.

Synthetic funded transactions had a 0% share in Q4 as well as in Q3. Cashflow and hybrid CDOs represent 61% of the Q4 issuance, while market value CDOs make up the remainder.

S&P enhances loan modification assumptions
Issuers can change loan modification terms in most instances by amending a transaction's pooling and servicing agreement, with an opinion of counsel, rating agency confirmation letter and/or certificate holder consent. With the number of load modifications rising, S&P has added several new steps to its existing criteria for such analysis.

First, the agency says it will analyse loan modification proposals under a variety of scenarios to assess the potential impact to the amended transactions. By their nature, loan modifications will result in a loss of principal, interest or both.

Consequently, S&P will evaluate whether any proposed modification programme allocates these losses to excess spread and overcollateralisation, to the extent available, then to the most subordinated class in the capital structure in the same way that ordinary losses resulting from defaulted loans would be allocated. If the proposed modification programme requires the servicer to re-underwrite loans, S&P will evaluate this underwriting based on its criteria for mortgage origination, underwriting, representations and warranties, and due diligence.

Non-agency MBS ETFs launched
Invesco PowerShares Capital Management has filed registration statements for two new actively managed ETFs focused on the non-agency, prime and Alt-A RMBS markets. The anticipated fund names are: PowerShares Prime Non-Agency RMBS Opportunity Fund and PowerShares Alt-A Non-Agency RMBS Opportunity Fund.

"We believe that various economic factors have converged to push the prices of many Prime and Alt-A residential mortgage-backed securities well below their fundamental values," says Bruce Bond, president and ceo of Invesco PowerShares. "We are hopeful that these ETFs will provide access and transparency into these markets, along with some of the much needed additional liquidity originally intended by the TARP."

Both funds will seek to provide total returns by investing, under normal market conditions, at least 80% of their assets in non-agency MBS collateralised by pools of either prime or Alt-A residential mortgage loans.

CDPCs' ratings withdrawn
Moody's has withdrawn its counterparty rating for Cournot Financial Products, as well as its counterparty rating and two provisional debt ratings (Aaa to the US$300m Series A and Aa2 to the US$100m Series B deferrable interest notes) for Quadrant Structured Credit Products (QSC). Both CDPCs are managed by Quadrant Structured Investment Advisers (QSIA), which has requested the ratings to be withdrawn for business reasons. The move follows QSIA's purchase of Cournot from Morgan Stanley in December (see SCI issue 116).

Hedge fund CFO criteria updated
Loss severities and marked reduction in underlying fund liquidity for hedge fund CFOs in 2008 have exceeded original expectations, according to Fitch, which has updated its rating approach on such transactions. Hedge fund returns, as represented by several multi-strategy indices, declined by approximately 20% to 25% in 2H08. Fitch has also observed reductions to hedge fund CFO liquidity (including gating, restructuring, side pockets) in a range of approximately 5% to 40% of net asset value (NAV) in Q408.

The agency has consequently updated its analysis of hedge fund CFOs to reflect recent and expected increases in market volatility and reduced liquidity. To address short-term volatility in CFO performance as well as reporting delays from underlying hedge fund investments, Fitch's analysis applies a 10% haircut upfront to the most recent reported portfolio NAV. The 10% haircut was derived using the worst monthly return decline reported by Fitch-rated CFOs.

Fitch then determines a triple-B market value stress by incorporating historical returns from the CFO under analysis, returns of representative hedge fund indices and observed hedge fund liquidations. Transactions are analysed applying this stress, with adjustments made for structure-specific time horizons and rating levels. For example, notes with investment grade ratings must be able to absorb sustained sequential market value losses as was experienced in Q408.

To assess the impact of reduced liquidity to the CFO from underlying hedge fund suspensions, Fitch analyses the transactions using three scenarios with various liquidity stresses. At the same time, these fund assets are subjected to market value declines. The results from these scenarios provide an indication of a rated note's sensitivity to future changes in a CFO's liquidity profile.

It is important to note that Fitch continues to analyze transactions on a case-by-case basis. Additional considerations in its rating decisions may include: amounts of redemptions in the pipeline, cash balances relative to liabilities, the size of a CFO relative to its master fund, increases in strategy/fund concentration levels as transactions unwind/mature, and performance relative to an index and peers.

Irish bank issues CDO, CMBS
Melepard 1 CDO, a €1.2bn funded balance sheet securitisation, has been assigned final ratings by Fitch. The deal is backed by a geographically diverse portfolio of corporate and leveraged loans predominantly located in Western Europe and North America managed by Bank of Ireland.

The transaction is the second European CDO to be managed by the Bank of Ireland, which acts as counterparty to the transaction in various forms. Amongst others, it is the cash manager, the issuer account bank, the collection account bank, the swap counterparty, the originator trustee and the servicer.

The triple-A rated Class A notes priced at 10bp over and the unrated Class B notes at 40bp over. 85.5% of the pool was purchased at closing, with the remainder to be added during the six-month ramp up period.

Fitch has also assigned final ratings to Morrigan CMBS 1 - the first multi-borrower deal of loans related to Bank of Ireland's balance sheet. The transaction is a securitisation of 38 commercial mortgage loans that were not originated for securitisation purposes, with a total outstanding principal balance of €1.77bn. The 38 loans are secured by real estate located in Ireland, Germany and the Netherlands.

Sirrah Funding refinanced
The £2.7bn Sirrah Funding II, a project finance and utility bond CDO that closed in October and was subsequently tapped in December last, has been refinanced by DEPFA and Hypo Real Estate. According to S&P, the new notes are the only remaining debt obligations of Sirrah Funding II. All assets of the old Sirrah Funding II are charged to the secured creditors of the new deal.

AIG-managed CLOs hit
S&P has taken negative rating action on five CLOs managed by AIG Global Investment Corp. The rating agency lowered ratings on four tranches (whose ratings remain on credit watch negative), while the ratings on two additional tranches were placed on credit watch negative.

The downgrades and negative credit watch placements affecting Galaxy IV CLO and Galaxy V CLO reflect deterioration in the credit quality of the corporate loans in the underlying collateral portfolios of the transactions. Based on the 7 January trustee reports for these transactions, the current defaulted balances were US$13.8m and US$20.1m respectively. At the same time, the amount of collateral in the triple-C rated buckets for the Galaxy IV and Galaxy V transactions had increased to 10.8% and 7.3% respectively.

Distressed mortgage pricing solution launched
Response Analytics has launched a new pricing solution for distressed mortgages based on behaviour modelling and optimisation technology. The firm says that the offering not only makes it possible to determine the value of these under-priced assets, but also to direct their modifications so as to maximise collectible value. The solution operates at the loan level and, with the requisite data, extends to MBS as well as whole loans.

According to Response Analytics, borrower behaviour is not just a factor of income and FICO score, but is dependent on a wide range of other variables. Brent Lippman, the firm's ceo, says: "By applying advanced behavioural modelling and optimisation technology, our Distressed Portfolio Management solution can establish the optimised individualised workout for each distressed loan in the portfolio, based on terms that have a much higher probability of being met. Furthermore, within the solution our robust 'NPV Engine' uses a broad array of dynamic modelling factors which ensure the most accurate NPV forecasts."

Further, an Optimisation approach can take into account regulations or investor covenants that constrain the optimisation of workout options across the portfolio, as well as the investor's own time horizon. All of this information is used to calculate the real hold-to-maturity value of the entire portfolio. The investor can use that calculation to make an informed decision about whether to purchase the portfolio, and at what price, and can then direct the servicer to modify the loans accordingly.

Synthetic SF CDOs downgraded
Fitch has downgraded US$932m of notes from 12 US synthetic structured finance CDOs that reference RMBS, CMBS and other CDOs. These rating actions reflect the agency's view on credit events experienced to date, as well as industry and vintage concentration risks outlined in its revised structured finance CDO rating criteria released on 16 December 2008.

The magnitude of the rating actions range from one to four rating categories, with a total of 22 rated tranches downgraded. The six classes previously rated triple-A (comprising approximately US$315m of the US synthetic structured finance CDOs) retain investment grade ratings, while all remaining classes were assigned ratings below investment grade.

All but one of the affected CDOs have experienced at least one credit event, most of which have been losses on written-down RMBS reference obligations. Fitch expects the reference obligations that have experienced write-down credit events will continue to write down, causing further losses attributable to future credit events.

In addition, most of the counterparties in these synthetic transactions have the ability to call credit events on the reference obligations that have been downgraded to triple-C minus and lower. To date, however, no such credit event has been declared - despite many reference obligations being rated triple-C minus and lower among these 12 transactions.

A second driver of these rating actions is sector concentration in the structured finance reference portfolios. RMBS sector concentration, predominantly in the sub-prime RMBS sub-sector, averages 70% in these transactions. Exposure to a single sector of structured finance securities can significantly increase portfolio default rates, as the correlated reference obligations would likely face the same macroeconomic pressures.

All classes were assigned stable outlooks, reflecting Fitch's expectation that the ratings will remain stable over the next one to two years.

Equity CDS index shows improvement
The cost of buying default protection on the S&P 100 entities, as measured by the S&P 100 CDS Index, has begun to show improvement. The index spread improved to 131bp, down from 146bp a week ago (see last week's issue) and 142bp at 2008 year-end. The S&P 100 Index has fallen by over 7% this year.

The leveraged loan market also continues to demonstrate improvement: as measured by the S&P/LSTA US Leveraged Loan 100 Index, the loan market has achieved a year-to-date return of 7.87%, while the average bid price for loans in the index has seen an improvement of over 5% to date.

CDS analytics engine available industry-wide
JPMorgan has transferred to ISDA its CDS Analytical Engine. Originally developed by the JPMorgan's quantitative research, the engine is widely used in the industry to price CDS contracts. ISDA will make it available as open source code, thereby increasing transparency around CDS pricing.

"JPMorgan has invested a lot of intellectual capital in this analytical engine. Its willingness to assign this to ISDA for us to make it available as open source to the entire industry demonstrates our collective commitment to the integrity of the CDS product," comments Robert Pickel, executive director and ceo, ISDA. "ISDA and its members are vigilant to public concerns around transparency. This is yet another measure of increased standardisation in CDS."

Japanese SME CLOs impacted
Moody's has downgraded and left on review for further downgrade its ratings on the senior and mezzanine trust certificates issued by two Japanese government SME CLOs - the 'CLO in September 2006 Regional Financial Institutions' and 'CLO in June 2007 Regional Financial Institutions' transactions. The downgrades reflect the decline in current credit enhancement, which resulted from deterioration in the credit quality of the transaction pool due to the ongoing economic slump.

The first CLO is backed by corporate loans originated by regional financial institutions and purchased by JASME (the Japan Finance Corporation) under its 'purchase scheme' securitisation programme, while the second securitises SME loans originated by JASME under its 'self-origination scheme' securitisation programme. The SME loans were originated with the intention of securitising them.

The ratings remain on review for further possible downgrade. Assessments will be based on the effect on underlying pool performance of the worsening economic environment and the Japanese government's policy to expand its guarantee programmes to support SME finance.

Banking Bill could impact UK triple-A SF ratings
The Banking Bill currently being considered by the UK parliament could - upon becoming law - have rating implications for S&P's analysis of deals up to and including the triple-A level where UK deposit-taking institutions are involved in any capacity, the rating agency said today (30 January). The Bill, which is expected to become law when the Banking (Special Provisions) Act 2008 (the B(SP)A) ceases to have effect after 20 February, is a replacement for the B(SP)A that was only ever intended to be a temporary measure.

"We understand that the Bill is likely to contain wide-ranging powers for the Bank of England to make orders effecting the full or partial transfer of ownership in and/or property of UK deposit-taking institutions that are failing or might fail. We also understand that the UK Treasury would be given the power to nationalise such institutions," explains the rating agency.

The breadth and nature of the powers in the Bill is causing concern among market participants, and S&P notes that the uncertainty this could give rise to may affect the type and level of legal comfort available for structured finance transactions involving UK deposit-taking institutions. "There could, therefore, be rating implications for our analysis of deals up to and including the triple-A level involving UK deposit-taking institutions in any capacity," adds S&P.

However, until the final form of the Bill is known (including the relevant secondary legislation), S&P will - where it considers it appropriate in all the circumstances - continue to rate securitisation debt involving UK deposit-taking institutions up to and including the triple-A level. However, once the form of the Bill and secondary legislation is known and in light of any other relevant developments and information, the agency will reconsider whether it continues to be possible to do so.

CRE delinquencies reviewed
In light of the deteriorating macroeconomic environment and its effect on commercial real estate delinquencies, Fitch has published its quarterly review of the largest specially serviced loans within US CMBS. The report highlights the 10 largest delinquent CMBS loans, as well as the 10 largest non-delinquent specially serviced loans.

Specially serviced loans range in size from US$86,647m to US$225m, with an average loan size of US$7.8m. While historical CMBS default curves show defaults peaking in years three through eight, there are a number of loans from the 2006 through 2008 vintages that have already been transferred to special servicing.

The 10 largest loans of concern within Fitch's US CMBS portfolio are currently with the master servicer, but have shown declines in performance as a result of current market conditions or will unlikely be able to meet stabilisation expectations at issuance.

RMBS-backed CDOs downgraded
Moody's has downgraded its ratings of 98 notes issued by 17 CDO transactions that consist of significant exposure to Alt-A, Option-ARM and sub-prime RMBS securities. The rating actions reflect Moody's revised loss projections for Alt-A RMBS securities.

On average, Moody's is now projecting cumulative losses of about 20% for 2006 securitisations and about 24% for 2007 securitisations. As a result of the revised loss projections, in most cases, subordinate Alt-A RMBS securities are likely to be completely written down. The agency says it is likely to downgrade the ratings of these securities to Ca or C.

Credit protection from structural features should provide most senior Alt-A RMBS bond holders with fairly high recovery rates, although approximately 80%-85% of all senior securities are likely to experience recoveries consistent with ratings lower than B3.

Rating confirmation policy further clarified
Fitch has further clarified its policy regarding rating confirmations. The agency says it has recently received an increasing number of requests for confirmations related to rating triggers applied to counterparties.

Rating triggers are often used with respect to counterparty risk to specify remedies to be followed when rating triggers are breached. Such triggers may be based upon Fitch's ratings, as well as the ratings of other agencies. The counterparty exposures involved may include swap or other derivative positions, account banks, qualified investments and/or liquidity facility providers.

With respect to counterparty risk in structured finance transactions, Fitch says it will always look to apply its then current criteria and will expect counterparties to honour the criteria in order for associated structured finance note ratings to be maintained. Transaction parties often choose to include specific rating triggers in transaction documentation that reflect rating criteria that were outstanding at the time of the transaction's origination.

However, rating criteria may change as Fitch analyses developments in the market or as its opinion of the risks involved changes. In the event that a counterparty continues to satisfy the provisions of Fitch's current criteria, the agency would not expect to downgrade the note ratings of a transaction exclusively due to the breach of any triggers specified in transaction documentation which no longer reflect Fitch's current criteria.

Nevertheless, the consequences under the transaction documentation of such a breach would be a matter for transaction parties to address. Fitch would expect to be notified of any action taken by the transaction parties in response to such a breach, which could cause the agency to take rating action or issue a commentary.

New ABX calculator unveiled
Barclays Capital has rolled out a new ABX Calculator tool on the Lehmanlive website. The tool has two components: an ABX calculator that computes yield tables based on BarCap's default/loss model; and an ABX surveillance tool.

The surveillance tool is designed to allow users to view index level characteristics and historical/projected performance across HPA scenarios. It also allows the user to easily drill down to the constituents of the index for this data.

The calculator shows yield tables for the ABX bonds and allows the user to compare yields for multiple indices across different HPA/collateral loss scenarios, BarCap says. The tool also shows cashflows on the ABX indices using model projections for each constituent deal.

Troubled company index improves
The Kamakura index of troubled public companies for January showed improved credit quality for only the second time in the last 18 months, decreasing 0.9% to 23.1% of the public company universe. Kamakura Corporation defines a troubled company as a company whose short-term default probability is in excess of 1%.

At the January level of 23.1%, the index shows that credit conditions are better than only 6.2% of the monthly periods since the start of the index in January 1990. "On January 6, Kamakura reported that US Shipping was among the rated companies with the largest one-month jumps in short-term default risk," comments Warren Sherman, Kamakura president and coo. "The company declared bankruptcy the following day. This month, among rated public companies, the companies showing the sharpest rise in short-term default risk were Royal Bank of Scotland Group, Allied Irish Banks and Entravision Communications."

Moody's to publish regular performance overviews
Moody's is to publish regular performance overviews of all ABS (as defined by the European Central Bank) that it rates publicly and which are included on the ECB's list of eligible marketable assets. The announcement is in response to the provisions of the 'Guideline on monetary policy instruments and procedures of the Eurosystem (ECB/2008/13)' (the 2008/13 Guideline), which was adopted by the ECB's Governing Council on 23 October 2008.

European RMBS analysis tool on offer
Fitch has launched a new model for European RMBS asset analysis called ResiEMEA. The tool is designed to help determine the expected default probability, loss severity and recovery on a loan-by-loan basis for transactions.

"Individual loan level performance data is vital for investors in the current market conditions," says Gregg Kohansky, md EMEA RMBS at Fitch. "ResiEMEA meets this demand for increased transparency and more accurate and predictive credit default assessment."

Available to arrangers, originators and investors, the model will be used by Fitch as the first stage in the quantitative analysis of an EMEA RMBS transaction. "The model provides a more rapid assessment of credit risk across residential mortgage loans," says Philip Walsh, md EMEA structured finance at Fitch. "This enables the user to fine tune mortgage portfolios and input closing pool cuts into ResiEMEA for surveillance purposes. Additionally, the outputs can be used for RMBS cashflow modelling purposes."

Initially covering the UK and the Netherlands, the model can process loan portfolios of master trust magnitude in minutes. The flexible interface allows users to adjust Fitch criteria assumptions and stress the loan, borrower and property-specific factors that most influence default probability and loss severity.

Ferretti defaults
Ferretti, the Italian luxury boat maker, has experienced a payment default and is currently in discussions with its lenders. CDO analysts at JPMorgan have found that, out of the €1.2bn loan, €329.4m is present in a sample of 47 European CLOs (or about a quarter of the market). Concentrations range from 0.4% to 5.6%, according to Intex data.

Best performance achieved for credit index
The Barclays Capital Credit Index tightened 62bp during January, outperforming duration-matched Treasuries by 319bp. This represents the best monthly performance since its return series began in the late 1980s.

The best performing sectors included home construction (TOL: +1,640bp; MDC: +695bp), lodging (led by MAR: +1,495bp), airlines (led by DAL: +1,503bp) and automotive (DAIGR: +1,722bp). The worst performing sectors included non-captive diversified (ACAS: -5,246bp; PHH: -4,912bp), supranationals (Asia: -53bp; EBRD: -50bp) and banking (RBS: -1,632bp; ING: -1,496bp). The banking sector results were driven in part by the significant underperformance of Tier 1 and Upper Tier 2 securities, BarCap notes.

Alt-A RMBS ratings lowered to default
S&P has lowered its ratings to single-D on 1,078 classes of mortgage pass-through certificates from 650 US Alt-A RMBS transactions from various issuers. It removed 26 of the lowered ratings from credit watch with negative implications. In addition, the agency placed 2,111 ratings from 143 of the affected transactions on credit watch with negative implications, while the ratings on 117 additional classes from 15 of these transactions remain on watch.

The downgrades reflect principal write-downs on the affected classes during recent remittance periods. Approximately 81.82% of the ratings on the 1,078 defaulted classes were lowered from the triple-C or double-C rating categories and approximately 98.98% of the ratings were lowered from a speculative-grade rating. S&P expects to resolve the watch placements affecting these transactions after it completes its reviews of the underlying credit enhancement.

Ex-Japan Asia outlook published
Fitch says in its special report, entitled '2009 Non-Japan Asia Structured Finance Outlook', that the more severe economic environment faced by non-Japan Asian countries may ultimately affect the performance of all asset classes within structured finance. In the report, the agency provides opinions on how the underlying assets and ratings of non-Japan Asia structured finance transactions will perform in 2009.

For the Korean market, the agency expects that the coming economic stresses, such as likely rising unemployment rates and possible home price depreciation, may pressure the securitised portfolios backing Korean cross-border securitisation transactions, such as credit card ABS, auto loan ABS and RMBS. Korean cross-border securitisation transactions may therefore experience increases in delinquencies and defaults in 2009. Nonetheless, due to the strengthened risk management approach and proactive asset quality control practices adopted by most Korean originators, Fitch expects that such increases in delinquencies and defaults of the securitised portfolios will be moderate.

The asset performance of Korean credit card ABS, auto loan ABS and RMBS transactions thus far has been within the agency's expectations. Fitch expects that the ratings of rated Korean cross-border securitisation transactions will remain stable in 2009.

The Singapore structured finance market, on the other hand, is characterised by real estate-related securitisations, including CMBS and residential receivables transactions. Since Q308, the prices and rental indices of the residential and commercial real estate sectors in the country have softened, coupled with the decrease in international visitor arrivals due to the global economic slowdown.

Fitch expects the fundamentals of underlying commercial properties collateralising Singapore CMBS transactions to weaken in 2009. Nevertheless, the agency expects that the ratings of most such deals will remain stable in 2009, due to the underlying properties' capabilities to generate healthy cashflows which exceed the agency's stabilised assumptions.

Based on Fitch's surveillance analyses, Singapore CMBS transactions - which were mostly issued during 2004-2005 - can withstand a 20%-50% decline in net cashflow before a rating downgrade is triggered. Additionally, refinancing risk for a few 2009 maturing Singapore CMBS transactions may emerge.

However, Fitch expects that such refinancing risk is limited, as the maturing CMBS transactions are performing well, with low current loan-to-value ratios. These are deemed positive credit features by both securitisation and bank loan markets. The agency expects the ratings of most Singapore CMBS transactions to remain stable.

Singapore residential receivables transactions will be affected by the softening of the residential market. Under the current market conditions, the residential property price decline may exceed the extent of price appreciation accumulated over the past two years. The declining residential property prices may also restrain buyers' capabilities to obtain loans from the bank mortgage market.

Fitch expects Singapore residential receivables transactions to experience an increase in buyer defaults in 2009. To address the resale value of the residential unit after a buyer default, Fitch has applied market value decline assumptions of 48%-58% on the transactions. The agency expects the outlook of Singapore residential receivables transactions to be stable to negative.

Updated CDOROM released
Moody's has released an updated version of its CDO modelling tool, CDOROM. The new version (v2.5) includes Moody's latest parameter assumptions for analysing CDOs backed by corporate and structured finance assets (SCI passim). Although the tool was primarily designed to model synthetic structures, it can also be used as part of the cashflow transaction modelling process.

CS & AC

CDS

More analysis on less CDS volume

Tim Brunne, senior credit strategist at UniCredit, looks at how CDS volumes are beginning to reflect the structural changes taking place in the market

Recent CDS volumes reflect the structural changes in the market. On 12 January Swedish firm TriOptima reported that the outstanding notional volume of credit default swaps had been cut by half in 2008, despite continued trading activity during that period (see SCI issue 119). The company establishes multilateral termination trades among CDS counterparties, which reduce the notional volumes of CDS counterparties but not the risk profiles of their respective portfolios.

This is confirmed by data provided by the DTCC, whose warehouse is said to hold records of approximately 90% of global CDS transactions and reported a total gross notional volume of US$29.3trn for the global market at 2 January. In this report, we take a look at the volumes in the CDS market at the beginning of 2009 by using the data that are published by the DTCC on a regular, weekly basis.

What will the market look like in one year's time? Blamed for a long time as being an opaque and essentially non-regulated market, surveys reporting the size of the CDS market were available only on a semiannual basis until October of last year (these were published by ISDA and the BIS).

We have been following the structural changes in that market throughout 2008. As these changes are still ongoing, the question arises about what the credit derivatives market will look like in one year's time.

Since the DTCC started to publish its market volume statistics in October 2008, the total outstanding volume of the market continued to shrink. Back in October, the DTCC reported a total volume of US$33.6trn, which declined to US$29.3trn as of 16 January. In the long run, this trend will continue as the importance of centrally cleared CDS increases in the future.

In the following, we analyse the descriptive data DTCC disclosed on 2 January, focusing on outstanding volumes and disregarding weekly market activity. Certainly, the data released by DTCC provide even more detail than what is displayed in Exhibit 1. But even the charts presented here provide great insight into the market - information that has not been available before from public sources.

The two major quantities that describe the size of the CDS market are gross and net notional volume. These two quantities and the corresponding number of contracts are provided by DTCC on a weekly basis on its website.

Gross notional volume is simply the sum of all notional deal volumes of all CDS contracts the DTCC covers in its database (obviously without double counting). DTCC explains it as follows: "Gross Notional Values are the sum of CDS contracts bought (or equivalently sold) for all Warehouse contracts in aggregate, by sector or for single reference entities displayed. Aggregate gross notional value and contract data provided are calculated on a per-trade basis."

Net notional volume is the sum of the volume of the net CDS exposure of any counterparty with respect to some underlying. DTCC defines net volume in the following way: "Net Notional Value with respect to any single reference entity is the sum of the net protection bought by net buyers (or equivalently net protection sold by net sellers). The aggregate net notional data provided is calculated based on counterparty family. A counterparty family will typically include all of the accounts of a particular asset manager or corporate affiliates rolled up to the holding company level. Aggregate net notional data reported is the sum of net protection bought (or equivalently sold) across all counterparty families."

In the semiannual survey provided since a few years ago by the BIS, gross net value is also reported. Although gross net value describes the economic importance of outstanding CDS positions, it is not reported in DTCC's weekly data distribution. All volumes are in US dollars in order to facilitate volume comparisons.

Exhibit 1 describes the general distribution of market volumes among the single name, index and index tranche CDS. The volume of index CDS has grown faster during the past years than for single name CDS, as shown by the semiannual surveys of the BIS and ISDA.

Exhibit 1

The fact that index CDS volumes (including tranches) have not surpassed single name CDS is related to the fact that multilateral termination trades are easier to implement for index trades. Apparently, multilateral cancellation trades have not targeted tranche CDS very much.

Index tranche volumes are surprisingly large. The right chart in Exhibit 1 demonstrates that the five to 10 million deal size (euro and US dollar) is prevailing for single names, whereas the indices and tranches trade in much larger sizes, on average.

Index and tranche CDS
Index CDS volumes are confirming where the market is most active: the investment grade indices CDX.NA.IG and the iTraxx Europe (main index) attracted the vast market share. In Exhibit 2 these volumes are not visible.

Exhibit 2

The gross (net) index CDS notional volumes are US$5.7trn (US$435m) and US$5.8trn (US$444m) for the CDX and iTraxx respectively. Gross notional volumes of investment grade indices exceed the speculative grade CDS indices (CDX HY and iTraxx Crossover) by a factor of 7.6 in both cases.

The Asian iTraxx markets are either surprisingly small or not represented similar to the US and European index CDS markets in the DTCC database. With respect to gross notional, the DTCC data suggest that iTraxx Europe Main and the CDS.NA.IG represent roughly 40% of the global CDS market and about 80% of the index CDS market.

These figures include the tranches on the investment grade indices. Apart from the standard corporate CDS indices in the US and Europe, the LCDS index LCDX.NA, the ABX.HE and the CMBX attract the most volume.

There are two further aspects that we can learn from the DTCC data with respect to index CDS trading. The left chart in Exhibit 3 repeats the gross volume levels by index (albeit with a different scale on the y-axis), but it also comprises the average deal size: not only is the outstanding volume of the IG CDS indices much larger than that of the HY indices, but the average deal size is also approximately twice as large for the investment grade sector compared to the high yield indices. The Asian iTraxx, leveraged loan and structured finance indices are trading in volumes that are closer to the single name CDS market than the CDX and iTraxx index markets.

Exhibit 3

Another very interesting aspect concerns recent index trading activity (in the running series) and the importance of the roll trades in CDX and iTraxx indices. As depicted in the right chart in Exhibit 3, gross notional volumes in running series are typically less than 10% of the total volume in the respective index. This means that there is a huge volume of outstanding deals in former index series, which are no longer as liquidly traded as the running series.

Also, the roll trade is not as important as we had anticipated. Rolling index exposure into the new series after the semiannual roll data ensures that the risk exposure (or protection) is always in the most liquid index. In addition, the maturity profile can be maintained by these trades.

Evidently, many dealers prefer not to cancel their positions in old series when a new series is starting. An additional driver behind the comparatively low volumes in running CDX and iTraxx index CDS is probably a mildly reduced trading activity in running series indices since the last roll date, which was at the same time when the collapse of Lehman pushed credit derivatives markets into significant restructuring and rebalancing activity, with respect to CDS indices clearly related to the former series.

Single name CDS
The importance of volume data at the single name level is clearly to assess the economic impact of a default event. If a CDS default event is triggered, single name CDS net notional volumes provide an indication of how much cash is potentially transferred to settle triggered single name CDS, assuming that the majority of counterparties opt for a cash-settlement according to the result of a recovery auction.

The total outstanding gross volume of single name CDS in DTCC's database amounts to US$14.8bn; the distribution among sectors is depicted in the left chart in Exhibit 4. The major share goes to the corporate sector (and within that to financial sector companies), followed by sovereigns. Only a very small volume of structured credit CDS is reported by DTCC.

Exhibit 4

Among corporate CDS, the average deal volume is around US$7m, which shows that the small US$5m (or €5m) deal size is surprisingly popular. Sovereign CDS are traded in bigger chunks, as well as CMBS CDS.

Another piece of information, the maturity profile of single name CDS, is shown in the left chart in Exhibit 5. As commonly known, the most frequent maturities that are traded are the five- and ten-year maturities.

Exhibit 5

The peak in the chart representing maturities of more than three years up to a maximum of five years is surprisingly large. This indicates that the DTCC volumes for five-year CDS in DTCC's database have increased substantially over the past 1-2 years, or that single name CDS have been rolled more than index CDS, which is not common practice.

Although single name CDS volumes for maturities up to three years could be under-represented in the DTCC universe, we think that it is more likely that financial and sovereign CDS volumes have grown massively over the past two years and are the reason for the spike. Maturities of more than 10 years showing a small hump around the 28-year bucket should mainly stem from structured credit CDS.

Finally, we turn to the volume distribution among single name CDS reference names. As depicted in the right chart of Exhibit 5, the 100 most important names in terms of outstanding gross notional represent a 31% share, while the 1000 names listed by DTCC comprise 96% of the single name volume (US$ 14.8bn).

The majority of single name CDS reported (69%) have a gross notional of less than US$32bn. With respect to the same fraction of 69% (but not the same set of names), the corresponding upper bound for the net notional is US$2.45bn.

The total fractions of names with volumes below these two respective bounds are of course much larger. The concentration of net notional volume on the largest reference names is less pronounced than for gross notional (see Exhibit 5). This corresponds to larger trading activity.

The two charts in Exhibit 6 depict the frequency distributions of the 1000 single name CDS reference names that were published by DTCC as the most important ones on 2 January.

Exhibit 6

What one would intuitively expect is confirmed by the data: as the single name CDS volume decreases on the respective scales shown, the number of reference names increases strongly. Although this trend must obviously reverse when approaching zero volume, the peak in the right-hand chart (net notional) is simply related to the fact that the DTCC only reports the volumes of the 1000 most important names (presumably selected according to gross notional).

Of the top 50 reference names with respect to both gross and net notional volume, the most important CDS single names are sovereigns. The list is certainly subject to changes over time, but sovereigns and financials always remain the most traded reference names in the single name universe. Interestingly, among the non-financial names in this list, there are many telecom sector corporations.

As outlined above, the sector with the largest outstanding volume is the financial sector and the consumer goods and services sectors, although the aggregated (cash) debt in these sectors is smaller than aggregated government debt. As the number of sovereign reference names is smaller than the number of names in corporate sectors (financial as well as non-financial), an aggregated corporate-sector notional-volume therefore potentially exceeds the sovereign CDS aggregated volume.

© 2009 UniCredit Research. All rights reserved. This Research Note is an excerpt from UniCredit's 'Structured Credit Update', first published on 23 January 2009.

Trading

Trading ideas: trash compactor

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

The credit-equity trampoline continues to bounce equity and CDS levels to different highs and unequal lows. Current equity prices are inexpensive when compared to CDS-implied fair value.

As with our other CSA trades in January, we find now to be an excellent time to buy CDS protection and go long a company's stock. When upcoming earnings are thrown into the mix, we see an additional catalyst to pull the two securities back in line with each other. We recommend buying CDS protection and buying shares of Waste Management Inc (WMI), a name due to announce earnings on 12 February.

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 alternating between trading too wide and too tight, WMI's CDS moved decisively tight to fair value in January, raising our expectations of a sell off. Our directional credit model also points to WMI CDS deterioration.

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

Exhibit 2

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.

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

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

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a different than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Government actions: Bailouts, stimulus packages and other governmental interventions have distorted the credit/equity relationship among certain names.

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

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

Liquidity
Liquidity (i.e. the ability to transact effectively across the bid-offer spread) in the equity and CDS markets drives any longer-dated trade. Our data on liquidity, created from the volume of bids, offers and trades that we see each day, reassure our trading in WMI. WMI is a reasonably liquid name and CDS bid-offer spreads are around 10bp-15bp.

Buy US$10m notional Waste Management Inc 5-Year CDS at 113bp.

Buy 22,000 shares Waste Management Inc at US$31.19 to pay 113bp 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).