Contents

Investors

Credit selection revisited

But future role of ABS/structured credit remains unclear

The credit allocation process is increasingly being governed by policymakers. Consequently, investors are revisiting the art of credit selection, but it remains unclear what role ABS/structured credit will play in the future.

One approach in this "new credit paradigm" is to identify which areas of the market are likely to receive policy support, according to PIMCO head of European credit and ABS portfolio management Luke Spajic. For example, policymakers in the US are driven by the desire to prevent the collapse of the housing markets, so efforts are being made to cap mortgage rates and channel credit via the GSEs (see also separate News Analysis story). Similarly, policymakers are taking equity and preferred equity stakes in banks, as well as providing senior loans and guaranteeing their issuance in order to kick-start lending.

But these initiatives took a new turn on Monday (9 February), with the announcement that the French government is lending €3bn each to Peugeot and Renault on the condition that no jobs are lost. Not only does the move indicate that government support is expanding from financial institutions into industrial sectors, but it also smacks of the need to protect companies that are perceived to be national champions.

"Peugeot and Renault are trading tight to other autos because it's clear they have backstop support from the government," explains Spajic. "The credit allocation process appears to be morphing into a competition among policymakers: if one country bails out one industry, then other countries will likely follow. Given that taxpayers now have some skin in the game, bailouts are being driven by political parameters rather than pure commercial reasoning."

Consequently, for PIMCO the implications for credit selection under the new paradigm are: the alignment of interests/co-investment with policymakers; choosing credits that are under the umbrella of policy support (which are likely to emerge from sectors with many employees, regulated industries, sectors affected by liquidity shortage rather than solvency risk and industries where other governments are already lending); and being senior in the capital structure. The caveats here though are EU competition law and more broadly the ability of sovereigns to raise money and keep their currency stable.

Picking credits beyond these sectors is more complicated: will retailers get bailed out, for example? Spajic suggests that the market might already be witnessing the beginning of the next stage, with government supported institutions being mandated to lend to SMEs.

Nonetheless, Spajic says that the Bank of England's move to purchase £50bn of corporate credit should provide a strong bid for credit more generally, given that the market's size is around £150bn. "This is a remarkable policy impetus to ensure that the credit market remains liquid and that corporates maintain their access to the capital markets," he notes.

He adds: "Demand has changed rapidly: two years ago the credit market was split 80/20 between levered investors and real money accounts, but the balance of power has shifted towards unlevered investors. Now real money investors are the marginal price setters of credit - and adding the BoE to this mix creates powerful support for the market."

While investment grade bonds are the clear winner in this scenario, the future for ABS and structured credit is less clear. The flows of new product will likely comprise simple ABS (such as student loan and credit cards), which is easily understandable and can survive in a less levered format. And the stock of existing product should continue to benefit from central bank liquidity.

The central question for the market remains whether there is a natural buyer for ABS and/or structured credit product, given that it is critical to understand the risk and know how to trade it. "Much of the infrastructure surrounding structured credit has disappeared," notes Spajic.

"However, as banks' balance sheets begin to be repaired and they have excess cash to put to work, they're starting to buy back their own ABS and to support their own issues in the secondary market," he concludes. "There is also evidence that new sources of demand are entering the broader credit market: government bond investors looking for yield; equity investors realising that they can achieve as good a return as equity but with a third of the volatility; and - of course - policymakers are also buying credit."

CS

LCDS

Recoveries reviewed

Focus turns to DIP structures in CDS auctions

The role of debtor in possession (DIP) financing and its impact on CDS settlements is set to become an area to watch in the coming months, as their involvement in the process has the potential to lead to low recoveries. At the same time, market participants warn that if the relatively low LCDS recovery values seen over the past few weeks become a sustained trend, further pressure on the leveraged loan and CLO markets could be in store.

DIP structures and collateral allocation mechanisms (CAM) have been causing unforeseen complications in CDS and LCDS auctions over the past few weeks. The Lyondell CDS/LCDS auction held last week, for example, highlighted the effect of the DIP structure on the cheapest-to-deliver loan. In this case, the cheapest-to-deliver loan was without rights, had been primed by the DIP and was trading flat with the secured bonds that were the only other deliverable into CDS.

According to Barclays Capital US credit strategist Bradley Rogoff, the issue was further complicated by the CAM provision governing Lyondell's loans in the event of bankruptcy. He explains that the CAM requires conversion of loans to a strip containing all pro-rata tranches, including non-US loans.

"Since the company's non-US loans are at a different entity and not deliverable into Lyondell LCDS/CDS, physical settlement would require the over-delivery of strips into CDS/LCDS to compensate for the non-US composition," he says.

Market participants decided that the CAM would permit the various tranches to trade separately, thereby resolving the over-delivery issue, which would have indirectly depressed loan recoveries. "The auction highlighted the possibility for low LCDS recoveries when DIP structures result in loans without rights to participate in new financing being the cheapest to deliver," continues Rogoff.

Numerous CDS settlement auctions have been held since the beginning of the year, most of which have witnessed disappointing results (SCI passim). Structured credit analysts at UniCredit suggest that, if a trend becomes visible where LCDS recovery values are in the 20% to 30% range, this should lead to further pressure on the leveraged loan markets, including CLOs.

Just yesterday (10 February) the results of the credit event auctions for Nortel Networks Corporation and Nortel Networks Limited determined the prices to be 12% and 6.5% respectively (see News Round-up).

AC

Distressed assets

Lacking in detail

Financial Stability Plan disappoints the market

US Treasury Secretary Timothy Geithner yesterday (10 February) revealed the Financial Stability Plan, the Obama Administration's answer to the troubled assets and capital constraints of financial institutions, as well as the frozen secondary markets. But he failed to answer the most important question for the market - how will the plan work?

The lack of detail leaves room for interpretation and uncertainty, notes Agnes Kitzmüller, credit strategists at UniCredit. "The risk is that the market reaction sabotages the plan before it gets under way, forcing Geithner to change his approach and making the new plan just an interim step, as happened several times to Henry Paulson," she says. The market's reaction was clear, as the Markit iTraxx Main and Crossover indices widened 8bp to 152bp and 34bp to 1034bp respectively on the news.

The Financial Stability Plan comprises the creation of a Financial Stability Trust, comprehensive stress-testing of major banks, increased balance sheet transparency and disclosure, a capital assistance programme, a public-private investment fund, a consumer and business lending initiative, a transparency and accountability agenda, affordable housing support and foreclosure prevention plan, and a small business and community lending initiative.

The implementation of the plan will first require banking institutions to go through a stress test in order to assess the risk on balance sheets. Those institutions that need additional capital will be able to access a new funding mechanism (the Financial Stability Trust) that uses funds from the Treasury as a bridge to private capital.

The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support. The terms should also encourage institutions to replace public assistance with private capital as soon as possible.

Second, the Fed, the FDIC and the private sector will establish a Public-Private Investment Fund to provide government financing to help leverage private capital in getting private markets working again. The fund will be targeted at the legacy assets on financial institutions' balance sheets.

"By providing the financing the private markets cannot now provide, this will help start a market for the real estate-related assets that are at the centre of this crisis," Geithner explained. "Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets."

The Treasury says it is exploring a range of different structures for the programme and will seek input from market participants as it is being designed. Though the programme is expected to ultimately provide up to US$1trn in financing capacity, it will begin with US$500bn and expand accordingly.

But, as Kitzmüller points out: "We already expressed our concerns previously as to how Timothy Geithner will manage to attract private money into a bad bank. He remained vague about this essential part."

Third, working jointly with the US Federal Reserve in dramatically expanding the TALF programme (see also separate News story), the Treasury is prepared to commit up to US$1trn to support a consumer and business lending initiative. This initiative is designed to kick-start the secondary lending markets, bring down borrowing costs and help get credit flowing again.

"In our financial system, 40% of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitisation markets for sound loans made to consumers and businesses - large and small," Geithner continued.

Purchases via TALF will be limited to newly packaged triple-A rated loans, but its reach will be broadened to include CMBS. In addition, the Treasury will continue to consult with the Fed regarding possible further expansion to include other asset classes, such as non-agency RMBS and assets collateralised by corporate debt.

Meanwhile, the Treasury will soon announce a comprehensive plan designed to stem foreclosures and restructure troubled mortgages. This will include spending as much as US$600bn on purchasing GSE MBS and GSE debt and committing US$50bn to prevent avoidable foreclosures of owner-occupied middle class homes by helping to reduce monthly payments in line with prudent underwriting and long-term loan performance.

As part of this effort, loan modification guidelines and standards for government and private programmes will be established. Furthermore, all Financial Stability Plan recipients will be required to participate in foreclosure mitigation plans consistent with Treasury guidance.

Finally, President Obama, the Treasury Department and the SBA will in the coming days announce the launch of a Small Business and Community Bank Lending Initiative, which will seek to facilitate increased SBA lending.

The Stability Plan has the whiff of compromise about it, according to Gavan Nolan, vp credit research at Markit, and at first sight it appears that some of the measures could clash. "Private investors wishing to provide funds for the 'bad bank' will be obliged to value the distressed assets themselves," he notes. "Putting aside the well-known difficulties in the MBS/ABS market on liquidity and valuation, an additional problem could be created by one of the other facets of the plan. The proposal to modify mortgages could make the securitised assets more difficult to value and therefore discourage participation in the 'bad bank'."

However, SIFMA president and ceo Tim Ryan says he is encouraged by the creative and wide-reaching suite of programmes outlined in the initiative. "It appears as though the Obama Administration is wisely applying some of the most important lessons learned during the S&L crisis, using public-private joint financing to encourage the return of private investment," he comments. "That capital will be the cornerstone to reestablishing a healthy market, especially if those purchases are made openly and transparently."

Ryan adds: "When additional details are provided, we hope the administration will include methods for the public and private sectors to share upside profits and downside risk - another successful approach used during the S&L crisis, which both brought back private sector buyers and limited taxpayer losses."

CS

CDPCs

CDPC outlines asset management plans

Primus Guaranty outlined, during its Q4 earnings call, its plan to tap new opportunities in structured credit asset management. Together with acquiring assets from motivated sellers, the CDPC's strategy includes potentially establishing an alternative credit protection business.

Tom Jasper, Primus ceo, explained that consolidation among structured credit asset managers, as well as financial institutions exiting the business will provide opportunities to acquire assets, as credit fundamentals continue to deteriorate. The company continues to focus on opportunities within the loan market and more specifically on acquiring collateral lines, loan obligations, management companies and/or management contracts.

He also said that, in the current environment, there could be "interesting possibilities" for a rated collateralised seller of credit protection. Jasper stressed that credit protection remains a good business and that the credit markets should be crying out for new risk taking capacity.

The company is looking to identify strategic partners to build a diversified credit asset management business. It believes that organisations seeking to capitalise on opportunities in credit will prefer to partner with a company that has a proven asset management platform.

Indeed, the recent rise in value of the publicly traded Primus holdco debt, PRD (listed on NYSE), indicates that investors believe possibilities for growth at the company remain. Bradley Golding, md at Christofferson, Robb and Company, suggests that investors are pricing in the fact that Primus will have money at the holdco level even if the opco (the CDS counterparty) blows up. The company has roughly US$75m in cash at the holdco and US$110m debt.

Meanwhile, the company say it intends to amortise Primus Financial's credit protection portfolio; in other words, it will not focus on writing new business to grow its portfolio and, as a result, the portfolio will decline in size over the next three to four years. Approximately US$2.6bn notional of its credit swap portfolio will roll off in 2009 and US$5.9bn in 2010. The amortisation process will include targeted credit mitigation on reference entities that are experiencing credit problems, as well as a broader restructuring of the credit swaps portfolio, which would necessitate coordination with Primus Financial's counterparties.

Finally, Jasper confirmed that the company will continue to target an appropriate rating for Primus Financial, whether it is established by an outside rating agency or through its internal capital models. The company plans to maintain ratings with S&P only, having asked Moody's to withdraw its ratings.

CS

CLOs

New assumptions prolong uncertainty for CLOs

Moody's has revised and updated certain key assumptions that it uses to rate and monitor CLOs, following in the footsteps of Fitch and more recently S&P. However, continued uncertainty about ratings methodology changes is expected to make capital constrained investors even more unlikely to be buyers of CLO products, with a near-term revival in senior tranche pricing looking increasingly more unlikely.

Specifically, Moody's has updated its default probability assumptions to reflect the significantly elevated corporate default rate expectations stemming from the global recession and tightened credit conditions. Moody's has also updated its calculation of the diversity score in response to the increasing complexity and interdependence of the global credit markets.

Moody's expects that the revised assumptions will have a significant impact on mezzanine and junior CLO tranches, resulting in a downgrade of their ratings by three to six notches on average. However, the impact from the revised assumptions on senior CLO tranches is expected to be small and to vary according to tranche subordination, tranche size and structural features, as well as transaction-specific characteristics such as vintage and portfolio composition. The agency notes that, in general, the cashflow diversion and de-levering structural mechanisms in many CLOs can provide significant protection to senior tranches in a stressed credit environment.

Using these updated assumptions, Moody's will immediately begin reassessing all of its outstanding mezzanine and junior tranche ratings from approximately 1,000 CLO transactions (totalling about US$400bn) across the US, Europe and Asia. The impact of these changes will vary across transactions, but structured credit strategists at JPMorgan have made some broad conclusions.

First, while current pricing on lower-rated CLO tranches is already severely depressed, an actual change in rating several notches down may induce some ratings-based investors to reassess holdings. While it's not clear how much forced selling would emerge, there would obviously be more potential supply of mezzanine and subordinate bonds entering the secondary market.

Second, more conservatism around required subordination levels per CLO rating would impact the still-recovering primary market, as diversification and tranching requirements would probably become more onerous. However, it's not clear whether these revisions substantially impact transactions already in the pipeline or in the near future, as the strategists feel the market is in any case moving more generally towards lower leverage, more careful use of portfolio flexibility and simpler structures (see last week's issue).

Third, CLOs that hold other CLO tranches in the structured finance securities bucket, downgrades by Moody's on the CLO holdings would decrease portfolio ratings quality and in severe cases increase the triple-C bucket. Finally, downgrades of mezzanine or senior notes typically remove manager discretion to classify any asset as a credit risk or credit improved obligation and may prohibit usage of the discretionary trading bucket.

AC & CS

Indices

Hedge fund index fall decelerates

Both gross and net monthly returns for December 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index remained in negative territory, but showed some signs of deceleration.

The latest figures for the index were published this week and show a gross return of -0.62% and a net return of -0.74% for the month of December (compared to -5.87% and -5.99% respectively in November). The moves mean that the gross and net indices show negative annualised returns since outset of -10.28% and -12%. For more Index data click here.

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

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

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

CS

Operations

First-mover advantages for initial TALF deals

The New York Fed (NYFRB) has released additional terms and conditions - including loan rates and collateral haircuts - of the Term Asset-Backed Securities Loan Facility (TALF). Haircuts range from 5%-10% and, according to securitisation analysts at Barclays Capital, have been set aggressively to ensure maximum investor participation in TALF-eligible new issue ABS transactions.

"As such, we expect significant first-mover advantages for investors in the first few transactions," they say.

Haircuts on TALF loans will vary for each asset class based on the risk and maturity of the collateral pledged. The NYFRB will periodically review haircuts and interest rates and may make adjustments to remain consistent with the programme's policy objectives.

Under the TALF, the New York Fed will lend up to US$1trn to eligible owners of triple-A rated ABS backed by newly- and recently-originated auto loans, credit card loans, student loans and SBA-guaranteed small business loans. Eligible collateral may be expanded to include CMBS, non-agency RMBS or other asset classes (see also separate News Analysis story).

"We expect it to stimulate new issue activity for the duration of the programme; however, in and of itself, TALF does not address the fundamental problem plaguing consumer ABS - namely, the lack of traditional, real money investor confidence in the market," the BarCap analysts add. "The programme has attracted interest from hedge funds and opportunistic funds, which some real money accounts are establishing. However, unless non-leveraged investors return to the ABS market (both primary and secondary), it will be difficult to wean the market off the low-cost financing (i.e. leverage) provided by the government."

TALF-eligible ABS must have the highest long-term or short-term investment grade rating from at least two rating agencies (and not have a lower credit rating from a major agency). Eligible collateral will not include ABS that have credit ratings based on the support of a third-party guarantee, or ABS that a major rating agency has placed on review or watch for downgrade.

If ABS that was eligible for TALF financing is downgraded by a rating agency, this will not affect an existing TALF loan secured by that ABS; however, the ABS may not be used as collateral for any new TALF loans until it regains eligibility. Eligible collateral may not be backed by loans originated or securitised by the borrower or by its affiliate.

Investors tapping TALF may choose a fixed or floating (over Libor) rate loan. Unlike the original plan, there is no auction mechanism, making TALF financing available to all interested investors.

Each borrower must use a primary dealer, which will act as agent for the borrower, to access the TALF programme and to deliver eligible collateral to the FRBNY's custodian bank. Additionally, in order for ABS to be eligible collateral for a TALF loan, the sponsor of the securitisation that issues the ABS must be in compliance with the executive compensation requirements of the Emergency Economic Stabilization Act of 2008. Borrowers will not have to satisfy the executive compensation requirements, however.

AC

Trading

Illiquid incentives

Barry Silbert, ceo of SecondMarket, answers SCI's questions

Barry Silbert

Q: How and when did your firm become involved in the structured credit market?
A: I previously worked at Houlihan Lokey, where my focus was on restructuring and distressed workouts. This was during the time of the Enron and WorldCom defaults. The idea for SecondMarket was developed from my experiences there: to create a marketplace for different asset classes that are initially illiquid or become illiquid over time.

The SecondMarket platform launched in 2004, beginning in restricted stock/illiquid blocks of public companies and focusing on the apparent liquidity discount. We continued to build out the technology aspects of the platform, including the settlement mechanism, as well as developing a network of buyers and sellers.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: In order to prepare for what we anticipated would be a bad 2008 for the financial markets, we sourced some venture capital in 2007 to enable us to expand into other asset classes. The freezing up of the auction-rate securities (ARS) market in February 2008 provided us with our first opportunity to demonstrate that the SecondMarket platform could expand successfully. Within 1.5 weeks of the auctions failing, we were seeing volume in student loan, CDO and XXX ARS.

The next asset class to launch on the platform was for bankruptcy claims, where creditors can sell their claims rather than wait for years for them to be resolved. With around US$1trn of bankruptcy claims outstanding, we're adding efficiency and transparency to this process as well. We expect trading in this asset class to grow as bankruptcies increase.

Q: What is your strategy?
A: Our current focus is on rolling out four new asset classes, beginning this week with limited partnerships in hedge funds, private equity funds and venture capital funds. There is certainly a gap in the market for this, given the near term need for asset managers to gate funds or make capital calls relative to LPs' needs to rebalance portfolios and conserve cash.

The next asset classes scheduled for launch are private companies, CDOs and MBS. There is a need for price discovery and transparency in these sectors, and our model is tailored for such a scenario.

The main reason why these products are illiquid is because they are buy-and-hold investments and so there isn't much information available on the securities and not that many institutions are familiar with digging into the underlying data. We're upgrading the platform to try and help with this situation.

The current platform offers price discovery via the process of matching bids and offers. The new platform will include three new functionalities, the first being an auction process.

We've created a new type of auction for CDOs and MBS called a Manhattan Auction, whereby potential buyers are economically incentivised to make bids. Under this process, the seller carves out a portion of the proceeds which will be paid out to the bidders at its discretion.

There are two types of potential buyers: those that test the market with a minimal bid (and in so doing establish a floor price); and those that are serious about buying and so will bid aggressively (in which case the seller fee essentially serves as a discount on their purchase). Either way, the objective is to bring significant new private capital to the marketplace.

Anyone can bid, but they can't withdraw their portion of the fee until they've actually completed a transaction. This is to ensure that participants are bona fide in order to protect the integrity of the system. Most deals are settled through escrow, so there's no counterparty risk.

The second new functionality is to provide free data and analytics. We've gone through 2000 offering circulars and servicing reports and synthesised them into the basic information an investor would need to know about a certain asset.

The third functionality is the creation of an ecosystem, which enables investors to access third-party resources, such as valuation, research and data analysis, on the platform. So far 30 third-party organisations have verbally committed to being part of the ecosystem.

Q: How do you differentiate yourself from your competitors?
A: Obviously traders and/or brokers in the larger asset classes could conceivably compete with SecondMarket. However, we're focusing on complex assets that are difficult to value, so we'd encourage them to use our platform as a place to generate liquidity.

We have good relationships with participants in the CDO and MBS sectors, having established ourselves as an independent marketplace and not simply a technology platform. We're hiring aggressively and so there is always someone to call if a user has a question or if a seller wants us to handle a sale for them indirectly. Among our hires are Bill Seidman - the former chairman of the Resolution Trust Corporation (RTC) and Federal Deposit Insurance Corporation (FDIC) - who is a senior advisor, and Richard Gugliada - the former head of CDOs at S&P - who has helped us develop the data and analytics side of the business.

Q: Which challenges/opportunities does the current financial environment offer your business and how do you intend to manage them?
A: As well as working to bring in private capital (which will ultimately solve the market's asset overhang problem), we've had meetings with various governments about how we can help. Under the second part of TARP, for example, it is likely that sellers will have to agree to certain restrictions, so we could emerge as an alternative marketplace for asset liquidations. Alternatively, the Manhattan Auction could prove to be a useful way for the government to dispose of certain assets.

Q: What major developments do you need/expect from the market in the future?
A: Ultimately, we want to become the market leader in illiquid asset trading and so we have identified and are tracking around 50 different asset classes that we could potentially expand into over time. The timing depends on hiring the right people and making the right technology enhancements in order to create a world-class platform that is attractive to private capital.

About SecondMarket
SecondMarket (formerly known as Restricted Stock Partners) is the largest centralised marketplace for illiquid assets, such as auction-rate securities, bankruptcy claims and restricted securities in public companies. SecondMarket's online trading platform has nearly 2,000 participants, including global financial institutions, hedge funds, private equity firms, mutual funds, corporations and other institutional and accredited investors that collectively manage over US$500bn in assets available for investment.

In addition, SecondMarket facilitates all administrative and settlement support services for executing both private and public transactions involving illiquid assets. The company has the expertise to handle even the most complex transactions efficiently. Its team manages the entire process, from pre-sale due diligence through execution and settlement, to ensure regulatory compliance and the most efficient settlement possible.

CS

CastleOak adds two

The latest company and people moves

CastleOak adds two
CastleOak Securities has hired Hiram Matthews and Joseph McManus for its capital markets team. Matthews joins as senior md and head of structured products. He will focus on building CastleOak's structured products team in New York, as well as in the firm's regional offices in Atlanta and Chicago. McManus brings over 20 years of fixed income sales experience across a diverse set of products, including investment grade credit, ABS and CDOs.

Matthews was previously product manager of structured products for Barclays Capital. In this role he marketed Barclays' structured products throughout the US, Europe and Asia. McManus joins CastleOak from Morgan Stanley's investment grade credit product group.

Mooney joins NewOak
NewOak Capital has appointed Patrick Mooney as coo. Mooney has 23 years of experience at Bear Stearns, Thomson TradeWeb and SIFMA.

At Bear Stearns, he drove the firm's strategic foothold in fixed income & derivatives trading segments, while building and transitioning various businesses by facilitating integration of operations, legal, compliance, accounting and risk management teams into the firm's infrastructure, as well as trading, capital analysis, budgeting and management reporting systems. At TradeWeb, he assessed emerging trends, seized profit growth opportunities and leveraged a bottom-up approach to extend product visibility and gain market acceptance.

DIP investment fund launched
Aladdin Capital has launched a fund that will invest exclusively in debtor in possession (DIP) facilities. Understood to be the first of its kind, the fund will participate, structure and lend directly into both large-cap and mid-cap facilities. Aladdin says it is looking to capture meaningful market share now that many DIP financing providers have exited the market or curtailed lending activities.

The fund, which has one founding investor, is expected to offer attractive returns on an unlevered basis to pension funds, endowments and other institutional investors.

Victor Russo and Luke Gosselin have been hired by Aladdin as global co-heads and co-portfolio managers of the fund. Russo was most recently president of CIT Business Credit, an operating unit of CIT Group. Gosselin was most recently head of private principal finance at Goldman Sachs.

Russo and Gosselin also worked together for 10 years at CIT Group. Aladdin is currently putting together the rest of the fund's team, which is expected to comprise of members from CIT and Goldman Sachs.

Manager acquisition talks near completion
Aladdin Capital says it is in advanced talks for the acquisition of a CDO manager, which it hopes to complete by next week. Meanwhile, Cohen & Co is rumoured to have found a buyer for its CLO management arm, Emporia Capital. Details of who that buyer is have not yet been publicised.

Structured credit portfolio manager hired
CME Group has hired Yue (Nina) Chen as director, financial research and product development. In this newly created position, Chen will be responsible for identifying and developing new product and clearing opportunities in the OTC markets.

Her primary focus will be on credit markets, but will also extend into other asset classes including equities, commodities and fixed income. She will report to Eugene Mueller, director, financial research and product development.

Prior to joining CME Group, Chen most recently served as vp, Goldman Sachs Asset Management, where she was a junior portfolio manager on global structured credit products. She also worked at Goldman Sachs as a strategist for US interest rate products, including MBS, interest rate swaps and swaptions.

CDS strategist departs
Glen Taksler, credit derivatives strategist at Bank of America, is understood to have left the bank. His duties will be taken on by Ward Bortz.

CSO head on the move
Manoo Halati, head of CSO trading at Merrill Lynch in New York, is understood to have left his role.

Agency brokers seek cash salespeople
One Europe-based head hunter says he has seen a substantial increase in business for agency-broker job vacancies (see also last week's issue). In particular, he says that ex-structured credit/structured finance sales people are being targeted for the roles.

CDO exchanges complete
Reading International has bought back US$9.9m of preferred securities held by Kodiak CDO II. In a transaction which occurred on 3 February the CDO issuer accepted securities proposed by Reading for this exchange and the firm was again able to effect such exchange at a 50% liquidation discount.

As a result of this transaction, Reading expects to recognise an additional forgiveness of debt gain in its first quarter of 2009 of US$4.9m. Reading previously announced that it sought to reacquire up to US$22,925,000 of its preferred securities. This has now been accomplished and the firm does not foresee any further re-acquisitions of its trust preferred securities at this time.

Sargent joins GIB
Gulf International Bank (GIB) has appointed Robert Sargent as head of asset management at the bank's subsidiary in London, Gulf International Bank (UK) Ltd. Sargent has over 20 years' experience in asset management, largely developed at Morgan Stanley, where he ran the investment management business for Europe, Asia, Middle East, Africa and Australia. His most recent position was with Lehman Brothers Asset Management as ceo and business head for the EMEA region.

Besides asset management, GIB provides client-led, innovative financial products and services to a wide customer base in the GCC region, including investment banking, capital markets debt securities, private equity, project and structured finance and Islamic banking.

SNB stabilisation fund reduced
The stabilisation fund of the Swiss National Bank (SNB), which was set up to take on UBS' troubled assets, will acquire these assets for a lower maximum amount than originally planned. The SNB and UBS have agreed not to transfer certain categories of assets, comprising student loan ABS and assets that have been wrapped by monoline insurers.

As a result, the maximum volume of assets to be transferred will now decrease from its original level of approximately US$60bn to US$39.1bn. In accordance with the agreement announced on 16 October 2008, UBS will finance 10% of the transfer amount. Owing to the reduction of the overall amount, the maximum risk to be borne by the SNB has declined to roughly US$35bn.

Owing to amendments made to accounting standards in mid-October 2008 that apply to UBS, it is now possible to classify certain assets as loans and receivables, with the result that they no longer need to be valued at market prices. Instead, an impairment charge will only be necessary if there are permanent doubts regarding the repayment of the outstanding amounts. It is thus no longer imperative that these assets be transferred to the stabilisation fund, which operates with similar accounting standards.

New fund targets CDS
Standard Life Investments has launched a Strategic Bond Fund. The fund, which is available to retail investors with immediate effect, has a flexible mandate that embraces a holistic approach to investing in fixed income, Standard Life says.

The fund offers investors the flexibility to invest across the fixed income spectrum, including government bonds, investment grade credit, high yield and index-linked bonds, both in the UK and overseas. It can also take positions in derivatives, including futures, inflation or interest rate swaps and CDS to further enhance returns and minimise risk. The asset mix of the fund is expected to change significantly over time in order to take advantage of these different areas.

Wilmington exits CDO business
Trustee and corporate administrative service provider Wilmington Trust is to close its CDO and conduit services business due to lack of demand, according to its 2008 results.

ASF announces new chairman
The American Securitization Forum (ASF) has elected Ralph Daloisio, md at Natixis, as chairman. Daloisio's term began on 6 February and will end on 1 July 2012.

Daloisio previously held the post of chair of the ASF Investor Committee, evp of the ASF Management Committee and is a member of the ASF board of directors. He has been directly involved in a range of current issues that are at the forefront of ASF's advocacy agenda, including foreclosure prevention and loan modification initiatives, mortgage finance and bankruptcy reforms and market standards and practices initiatives to improve the securitisation market's infrastructure.

Daloisio succeeds Sanjeev Handa, head of global public markets at TIAA-CREF. Handa continues as a member of ASF's Board and Management Committees.

AC

Concerns over derivatives Bill highlighted

A round up of this week's structured credit news

Concerns over derivatives Bill highlighted
In testimony before the US House of Representatives Committee on Agriculture, Robert Pickel, ISDA executive director and ceo, addressed the Association's concerns regarding the Committee's 'Derivatives Markets Transparency and Accountability Act of 2009'. He said that portions of the Committee's Draft Bill would severely harm the derivatives markets and prevent them from functioning properly in the US, while also impairing the ability of American companies to hedge their risks. More importantly, the consequences of certain provisions of the Bill would harm many mainstream American corporations.

Pickel stated that the Bill's proposal to make it unlawful to enter into a CDS unless the person entering into the transaction would experience a financial loss upon the occurrence of a credit event would effectively eliminate the CDS business in the US (see last week's issue). The effect of the Bill would be to severely limit the use of the hedge exemption and thus access to the futures markets. This would likely result in more costly hedging, increased volatility, reduced liquidity and a deterioration in the price discovery function of futures markets.

In addition, the Bill would effectively give the CFTC the authority to cancel private contracts. This fundamentally undermines legal certainty, would make it difficult for parties to calculate how much capital to hold against such contracts and would likely cause a significant decrease in OTC activity.

Pickel also highlighted that, while clearing should be encouraged and market participants should continue to work with federal and international regulators to create a viable clearing solution for OTC derivatives, he said that mandating clearing of all OTC derivatives is unwarranted.

Unusual repo-linked deal closed
BNP Paribas has closed an unusual repo-linked transaction. The €150m limited-recourse notes Series 2009-1 issued through the Aquarius + Investments vehicle is a fully-funded arbitrage deal rated by S&P.

The single-tranche transaction is rated double-A (in line with BNP Paribas' rating), has a scheduled maturity of March 2014 and priced at 10bp over three-month Euribor. At closing, the issuance proceeds were used to enter into a repo agreement with BNP Paribas under which the bank transferred eligible collateral securities to Aquarius + Investments. On each repo date, the repo is rolled and the price differential paid by BNP Paribas covers the interest due under the notes.

Via a margin maintenance mechanism, the value of these securities is marked-to-market daily by the repo counterparty, so that the market value of the securities is at least equal to the outstanding notional amount of the notes plus a margin. These collateral securities comprise euro-, sterling- or dollar-denominated Pfandbriefe, corporate bonds, and financial institution and government bonds, all rated at least double-B minus. Moody's analysis does not rely on this embedded marked-to-market mechanism nor on the collateral securities but, rather, on the rating of BNP Paribas, since the bank makes the payments of both principal and interest on the notes under the repo agreement.

Events of default under the notes include failure to pay, failure to perform in a way that would materially prejudice the noteholders and bankruptcy or insolvency of the issuer. In this deal, the trustee can waive an event of default if it deems it not to be prejudicial to the noteholders' interests.

BoE seeks advice on ABS purchases
The Bank of England has published further details about how it intends to operate the Asset Purchase Facility. The Bank, which has been authorised to purchase up to £50bn of high-quality private sector assets under the Facility, will initially purchase commercial paper, corporate bonds and paper issued under the Credit Guarantee Scheme (see also separate News Analysis). Syndicated loans and ABS created in viable securitisation structures are also eligible, although these will not be purchased initially.

According to a statement released on Friday, the BoE is keen to discuss with interested parties how to make effective purchases of ABS and syndicated loans. In particular, the BoE says it is keen to investigate with interested parties the possibility of ABS structures that enable the purchase of assets that support the financing of smaller companies and/or companies of below investment grade credit quality.

The bank states that various structures are, in principle, possible in which the underlying assets comprise sterling-denominated corporate loans, with different investors, including the Fund, purchasing whole ABS, or equity or senior tranches. The BoE admits that such structures may take time to create. The Bank is keen also to explore whether other ABS may be used to meet the Fund's objectives - these may include trade receivables and equipment leases.

The Facility will initially purchase investment grade sterling CP issued by UK corporates, both at issuance and in the secondary market from 13 February. ABCP will not initially be eligible, although the BoE is willing to discuss with market participants the possibility of using this to enable a broader range of companies to use the facility.

Sanitec ...
Creditex and Markit, in partnership with credit derivative dealers, have announced the results of the credit event auctions conducted to facilitate settlement of LCDS trades referencing Sanitec first and second lien loans. The final price for Sanitec first lien loans was determined to be 33.5%.

The final price for Sanitec second lien loans was determined to be 4%, following the initial bidding period. This is because there was no open interest from market participants for physical settlement during the initial bidding period, removing the need for a second phase of the auction process.

... British Vita ...
The results of a credit event auction conducted to facilitate settlement of LCDS trades referencing British Vita first and second lien loans have been announced by Creditex and Markit. The final price for first lien loans was determined to be 15.5%; sellers of British Vita first lien LCDS protection will therefore need to pay 84.5% of the amount of protection they sold. The final price for British Vita second lien loans, on the other hand, was determined to be 2.875%; sellers of British Vita second lien LCDS protection will therefore need to pay 97.125% of the amount of protection they sold.

The price for the second lien loans was determined following the initial bidding period. This is because there was no open interest from market participants for physical settlement during the initial bidding period, removing the need for a second phase of the auction process.

... and Nortel settlement results in ...
Markit and Creditex have announced the results of credit event auctions conducted to facilitate settlement of credit derivative trades referencing Nortel Networks Corporation and Nortel Networks Limited, a wholly-owned principal operating subsidiary of Nortel Networks Corporation.

The final price for Nortel Networks Corporation was 12% and the final price for Nortel Networks Limited was 6.5%. The final price represents the recovery rate used to cash settle credit derivative trades subject to the ISDA 2009 Nortel Entities CDS Protocol.

... while Ferretti auction is announced
Markit iTraxx LevX index dealers have voted for a credit event auction to facilitate settlement of LCDS trades referencing Ferretti, which is a constituent of the LevX index. The auction terms, including the auction date, will be determined by LevX dealers according to LCDS auction rules published on the ISDA website.

Tranche relative value analysis released
Julius Finance has released an analysis demonstrating how JuliusProp, the firm's new relative value trading tool, can predict price movements in index tranches. Using the five-year tenor for CDX 9 as an entry point, the tool's cheap/rich indicator provided an 83% success rate over two days under the analysis.

The firm notes that a number of relative value trades could have been engaged on the basis of these results, including buying protection on 0%-3% and selling protection on 3%-7% or playing 7%-10% off either 15%-30% or 30%-100%. "All three of these trades have the added advantage that they are buying protection on the lower part of the capital structure. In this way, the trade isn't just milking moral hazard and could result in a profit windfall if any defaults did occur."

CDS-implied tranche ratings analysed
Moody's Analytics has released a ViewPoints paper demonstrating how Moody's CDS-implied ratings for corporate reference names, together with an analytic CDO ratings model (CDOROM), can be used to derive CDS-implied tranche ratings for CSOs. The firm says that the methodology is potentially valuable for investors to monitor, manage and hedge the credit and market risks of corporate CSO exposures.

Accuracy ratios for CDS-implied and Moody's tranche ratings were shown to be virtually identical: 89.2% for Moody's-based and 90.5% for CDS-implied. However, when triple-A rated tranches (which account for about 75% of total notional value) were excluded, the accuracy ratios are 54.5% for Moody's and 67.6% for CDS-implied ratings - suggesting that in the lowest ratings deciles CDS-implied tranche ratings have relatively higher discriminatory power.

The analysis involved rating 437 tranches of 127 historical static synthetic CDOs at monthly intervals between 2001 and Q308, using both Moody's ratings and CDS-implied ratings for the constituent corporate reference entities. The purpose of the study is to measure how tranche ratings might have performed, given certain changes to one key variable.

Among the study's other findings was that equity and mezzanine tranches exhibit negative initial ratings gaps that tend to diminish over time. A negative ratings gap signifies that the CDS-implied rating is lower (i.e. riskier) than the Moody's rating.

The initial ratings gap is largest and most persistent for mezzanine tranches. Over time, gaps are closed by the Moody's tranche rating moving toward the CDS-implied tranche rating.

Tranche ratings gaps on the deal origination date are highly predictive of future Moody's tranche rating downgrades: 59% of equity tranches, 70% of mezzanine tranches and 38% of senior tranches with negative initial ratings gaps were downgraded over a one-year horizon. Although CDS-implied ratings tend to be much more volatile than Moody's ratings at the reference entity level, CDS-implied tranche ratings were no more volatile than Moody's-based tranche ratings, experiencing higher rating stability rates, lower multi-notch downgrade rates and the same volatility of their Moody's Metric score over a one-year time horizon.

Adriana CLO repack closed
Ratings have been assigned to Bishopsgate Asset Finance Ireland Series 1, a £680m transaction that repackages notes from the NIBC-managed Adriana Infrastructure CLO 2008-1.

Bishopsgate will use the proceeds of the senior notes to invest in the €962.8m Class A-1 senior floating rate notes issued by Adriana. In order to achieve a higher rating than the purchased Adriana notes, Bishopsgate will divide the cashflows into a junior and senior tranche; the senior tranche representing the rated senior note and the junior trance a subordinated junior note of approximately £80m.

The Bishopsgate notes are matched in maturity to the Adriana note. They receive a Sterling cashflow through a swap with RBS. Moody's has assigned a rating of Aa2 to the Bishopsgate senior note.

TruPS CDO trouble ahead
TruPS CDOs could be at risk of events of default and losses on junior tranches if a significant increase in TruPS deferrals occurs, according to S&P. US banks are continuing to face intense pressure to conserve liquidity and capital, according to a recent report from the agency, which could prompt the banks to voluntarily defer payments on TruPS and preferred dividends.

In addition, the US government, as a result of the heightened sensitivity to public policy concerns and despite its position as an investor in the financial institutions receiving economic stimulus funds, could implement a broad-based policy mandating that banks defer their dividend payments. That policy could potentially include mandatory payment deferrals on bank TruPS.

Volatility decreases in US CDS index
A decrease in volatility was recorded in the US CDS market last week, according to data from the S&P 100 CDS Index. Index spreads fluctuated between 131bp and 134bp, closing on Thursday at 133bp.

By notional amount, 84% of this index was rated single-A or better at index inception on 22 September 2008. The S&P 100 CDS Index has had a positive year-to-date return of 0.46%, while the equity index has fallen by over 7%.

Index spreads for the S&P CDS US Investment Grade Index have fluctuated between 300bp and 310bp, closing on Thursday at 307bp. While all investment grade, 75% of the index is rated triple-B. The S&P CDS US Investment Grade Index Series 1 has had a year-to-date total return of 0.60%.

Ex-Japan Asia counterparty exposure detailed
Fitch has detailed the swap counterparty credit exposure in non-Japan Asia originated public cross-border structured finance transactions. Disruptions to the global banking and insurance markets from recent high profile defaults and mergers, coupled with the generally favourable performance of non-Japan Asia underlying assets, has turned the focus of investors from underlying asset performance to counterparty credit risk, the agency says.

Non-Japan Asian cross-border transactions are structured with swaps to deal with the currency and interest rate mismatches between the securitised assets and liabilities, and hence such transactions are subject to the credit risk of the swap counterparties. "Non-Japan Asian public cross-border structured finance transactions rated by Fitch do not have concentrated swap exposure to any particular financial institution other than Standard Chartered Bank, which reflects the frequent RMBS issuance by Standard Chartered First Bank Korea in the region. Besides, none of the non-Japan Asian ABS, CMBS or RMBS transactions have exposure to Lehman entities," says Stan Ho, senior director and head of structured finance ratings for Fitch in non-Japan Asia.

The top five swap counterparty exposures, expressed as a percentage of number of deals, in non-Japan Asian public cross-border structured finance transactions rated by Fitch are: Standard Chartered Bank (30.0%); ABN AMRO Bank N.V. (10.0%); HSBC (10.0%); BNP Paribas (6.7%); and Calyon (6.7%).

New quarterly highs for negative rating actions
Fitch says that negative rating actions by the agency for global structured finance (SF) transactions during Q408 touched new quarterly highs in many asset classes and key regions. As the recession took hold, both the RMBS and CMBS sectors saw the largest numbers of negative rating actions in Q408 compared with any previous quarter, in both the US and Europe, Middle East, Africa (EMEA) regions. Similarly, the Asia-Pacific (APAC) region also saw the highest number of negative rating actions for structured finance overall in Q408 compared with any previous quarter.

In the global CDO sector, the conclusion of the rating review following implementation of Fitch's revised corporate CDO criteria saw a large number of downgrades among investment grade corporate CDOs as rating watches were resolved during the quarter. Following the application of the new criteria to Fitch's portfolio of corporate CDOs, the cluster of credit events in September and October had a muted impact on ratings.

97% of triple-A corporate CDO tranches remained triple-A following the credit events. Of the ratings in the double-A category, 73% remained in that category, while only 12% were downgraded beyond single-A and all remained investment grade.

Globally, non-mortgage ABS saw the fewest negative rating actions, though upgrades declined to small numbers for all sectors. "Deteriorating credit fundamentals and the onset of a recession in the US have caused consumers to cutback on spending, with credit access for both financial institutions and households significantly constrained," says Glenn Costello, md and US SF risk officer at Fitch. "This is against the backdrop of continued home price declines across the US, but especially in sub-prime concentrated areas like California and Florida. Recent vintage sub-prime and Alt-A RMBS transactions represented a large proportion of downgrades in the quarter, with revised surveillance criteria being adopted. Credit and liquidity issues have also spread to the US CMBS sector with increased downgrades resulting from rising defaults and heightened expected losses on assets in special servicing, resulting largely from limited refinancing options."

The backdrop is similar in EMEA markets, especially in the UK and Spain. "The UK has now seen a decline in residential property prices of over 15% from peak to current trough and this is feeding through to higher loss severities on defaulted loans in RMBS transactions, particularly in the non-conforming sector which saw the bulk of RMBS downgrades during the quarter. Spanish RMBS and SME CDO transactions also saw heightened downgrade rating actions - especially amongst high loan-to-value and specialist lender RMBS and SME CDOs with particular exposures to real estate and construction, where recession in Spain has hit especially hard," says Stuart Jennings, md and EMEA SF risk officer at Fitch. "The general decline in commercial property values is the main reason behind downgrade rating actions in EMEA CMBS. Many downgrades were concentrated amongst City of London office transactions, where reported value declines have been in excess of 30% in some cases. While rental income remains fairly stable, more loans are expected to face financial difficulty as the recession deepens."

Fitch notes a record number of rating actions in Asia Pacific structured finance during Q408, the majority of which were driven by the downgrade of counterparties to transactions or corporates. Over 200 tranches (including public, private, international and national ratings) were downgraded, while seven were upgraded. Additionally, around 370 tranches were affirmed, accounting for approximately 30% of all outstanding tranches rated by Fitch.

"The negative prospects for future performance are reflected in the approximately 80 tranches currently on rating watch negative (RWN) and around 140 to which negative outlooks have been assigned," notes Alison Ho, director and head of performance analytics within the agency's Asia Pacific structured finance team. "As in Q308, most downgrades in Q408 were driven by external factors rather than by collateral deterioration, with CDOs once again being hardest hit by continued rating actions as a result of global corporate credit events in portfolios. The continued fall out from Lehman's bankruptcy affected not only CDOs but Japanese CMBS as well."

Negative outlooks are currently assigned to around 140 SF tranches, the largest portion being RMBS backed by loans in Australia and New Zealand, where Fitch's outlook on the providers of lenders' mortgage insurance is negative. The Rating outlooks on some CMBS is also negative, predominantly in Japan.

Ben McCarthy, head of Asia Pacific structured finance at Fitch, notes: "Although Q408 saw a record number of rating actions, Asia Pacific structured finance ratings generally performed well in 2008, as the impact of the global financial crisis was slow to reach the region. With the full force of the global crisis likely to hit the region in 2009, we expect negative ratings actions to be increasingly the result of asset performance - although deteriorating counterparty ratings, as evidenced by the current outlooks and negative watches, will continue to be a factor in future ratings actions."

RMBS loss criteria revised
S&P is revising its criteria for estimating projected losses for US RMBS transactions backed by sub-prime and prime jumbo mortgage collateral issued in 2006 and 2007. Due to the generally poor outlook for the US housing market, increased delinquencies and defaults, and residential inventory buildup, the agency is projecting that the underlying mortgage pools supporting sub-prime RMBS transactions issued in 2006 will experience aggregate cumulative losses ranging from 23% to 27%, with an average of approximately 25%, while pools supporting transactions issued in 2007 will experience aggregate cumulative losses ranging from 28% to 32%, with an average of approximately 31% of original principal balance.

Additionally, S&P is projecting losses on the underlying mortgage pools supporting prime RMBS in the 0.04%-13.54% range, with an average of approximately 3.65% for 2006 transactions, and 0.13%-19.52%, with an average of approximately 4.5% for 2007 transactions. The upper end of the loss ranges reflects the performance of a few outliers, while the majority of the transaction-specific loss projections are more closely distributed around the averages.

Speculative-grade default rate to hit 16.4%
Moody's default rate forecasting model is predicting that the global speculative-grade default rate will rise sharply for most of 2009, reaching a peak of 16.4% in November and then falling slightly to 15.5% by January 2010. The global speculative-grade default rate came in at 4.8% in January, up from a revised level of 4.1% at the end of 2008, says Moody's. A year ago the global speculative-grade default rate was much lower at 1.1%.

Between US and European speculative-grade issuers, Moody's default rate forecasting model predicts that they will peak at 16.4 % and 19.6% in the final quarter respectively. Across industries over the coming year, Moody's default rate forecasting model indicates that the consumer transportation sector will be the most troubled in the US and the durable consumer goods sector will have the highest default rate in Europe.

Moody's speculative-grade corporate distress index - which measures the percentage of rated issuers that have debt trading at distressed levels - ended January at 52.6%, slightly lower than the 54.7% level recorded a month earlier. In all, a total of 22 Moody's-rated corporate issuers defaulted in January 2009, of which North American issuers accounted for 15 of the defaulters (12 in the US and three in Canada), three were from Europe and the remainder was from other regions.

In the leveraged loan market, nine Moody's-rated loan issuers defaulted in January, out of which eight were from the US and one from Canada. The trailing 12 month US leveraged loan default rate rose to 4% in January from December's revised level of 3.5%.

Japanese SME CLO marketing
Moody's has assigned provisional ratings to a Y9.6bn transaction named Santoshi CLO 2009, which is backed by corporate loans to SMEs under the SME-related financial policies of three Japanese municipalities - Tokyo, Osaka and Yokohama. The transaction comprises four tranches of triple-A notes (three of which are fixed rate) and one rated Aa1, and is arranged by Sumitomo Mitsui Banking Corporation (SMBC).

The underlying pool consists of 272 obligors (the company with the highest total loan amount comprises approximately 0.9% of the pool balance). The originator/servicers are Shinkin Central Bank, The Tokyo Tomin Bank, The Yachiyo Bank, The Osaka City Shinkin Bank, The Bank of Yokohama, The Kanagawa Bank and SMBC.

The provisional ratings address the expected loss posed to investors by the legal final maturity date. The structure allows for timely payments of dividends and ultimate payment of principal by the scheduled redemption date with respect to the Class 1 trust certificates, and for timely payments of dividends and ultimate payment of principal by the final maturity date with respect to the Class 2 and 3 trust certificates.

The Class 1A, 1B and 1C trust certificates will be fully paid by principal collections from the underlying pool in June 2010, September 2010 and December 2010 respectively. Each set of scheduled principal collections from the underlying pool will total approximately Y0.56bn. The Class 2 and 3 trust certificates will be redeemed sequentially on a quarterly pass-through basis.

Moody's estimates the pool's annualised default rate at approximately 3.7%, based in particular on the historical performance data of past CLO transactions in the same programmes. Also taken into account are each borrower's default rate (through a quantitative credit assessment tool) and the historical performance data of the cities' subrogation payments.

The agency has also assigned provisional ratings to specified bonds issued by the Y0.6bn Santoshi CLO 2009 Tokutei Mokuteki Kaisha, which is backed by the Santoshi CLO 2009 deal. The transaction comprises three tranches of triple-A rated fixed rate notes due in 2010 and 2011.

Extension risk highlighted
Aside from pure negative credit trends, the risk of sponsors not calling bonds and lower prepayments are set to come further into focus in 2009, according to structured finance analysts at Deutsche Bank. They suggest that NIBC's non-call of Dutch RMBS deal SWAFE I last week brought a "certain reality" to extension risk and the consequent dramatic re-pricing (see also SCI issue 115).

"Non-call risk will be driven both by the fact such calls are currently deeply out of the money and the difficulties in finding alternative funding, particularly for weaker sponsors," the analysts note. "In this respect we continue to believe that pricing among certain Dutch RMBS does not reflect this risk. Aside from call-dependent structures, expected sharp falls in prepayments - particularly among floating-rate jurisdictions such as the UK - will increase extension risk as incentives to refinance recede."

Peru and Mexico see increased CDS liquidity
The latest data from Fitch Solutions' Global Liquidity Scores show that liquidity of CDS contracts on Peru and Mexico have increased in the last two weeks. The Peruvian economy is closely tied to commodity prices, in particular to those of base metals, which have fallen dramatically over the last six months. Uncertainty about the Mexican economy has increased due to its exposure to the US, where the slowdown continues to reduce demand for imported goods.

South Korean banks continue to dominate liquidity in the Asian corporate sector, with four of the top-five liquid CDS contracts being Korean banks. This highlights continued concerns, as the Korean banking system looks for foreign currency funding to roll over foreign loans, says Fitch Solutions.

Telecoms dominate liquidity in the European CDS market, with two companies in the top-five European corporates driven by increasing rumours surrounding M&A activity in the sector. In the retail sector, Alliance Boots has also entered the top five on the back of its planned merger with optician Dollond & Aitchison.

Meanwhile, Bank of America has moved up into the top five in the Americas as the market digests the fourth-quarter losses at Merrill Lynch and Bank of America.

Foxtrot Funding priced
HSH Investment Management has closed Foxtrot Funding 1 - a €1.57bn CDO. The discounted €1.773bn portfolio comprises 15,750 unsecured bank loans and corporate bonds (45.2%), CDOs/CLOs (47.1%), CMBS (5.93%) and ABS (1.2%). Rated by Moody's, the senior tranche is heard to have priced at 70bp over three-month Euribor and the mezzanine tranche at 300bp over.

Loan modifications analysed
ABS analysts at JPMorgan estimate that roughly US$266,000 securitised non-agency mortgages have been modified so far, with 97% being interest rate reductions and 3% principal forgiveness. The majority are sub-prime mortgages originated in 2006 and 2007.

A comprehensive, centralised source of loan modification reporting has yet to be established, so it has proven difficult to assess the magnitude of modification efforts to date. Nevertheless, the analysts have picked some criteria, based on LoanPerformance data, that they believe represent - if met - a loan modification:

• Borrower will be current after modification (could be current or delinquent before modification)
• Rate modification: hybrid ARMs - interest rate drops below the teaser rate; ARMs (after initial reset) - interest rate drops by more than 50bp, not on a reset date; FRMs - interest rate drops
• Principal forgiveness: the principal drops by more than 5%.

The rate modifications are all mutually exclusive and each rate modification could have a principal write-down associated with it as well, according to the analysts.

Accurate valuation requires consistent pricing policies
NumeriX and CMA have released a new industry report discussing the importance of consistent pricing policies for the accurate valuation of complex derivatives and structured products. The paper outlines the process of implementing an 'enterprise pricing policy' as a consistent, repeatable methodology for valuing complex financial instruments and creating an audit trail from the front to back offices. As a result, financial institutions can address the main challenge for today: developing the necessary internal support for complex products.

The credit crisis has revealed the market inefficiencies and forced institutions to evaluate their participation in complex markets in terms of the valuation, model validation and overall risk management involved with structuring and managing portfolios, the two companies note. While organisations will continue to invest in software to develop better pricing strategies, there are several key requirements to meet: standards between trading desks, which support different asset classes; model validation for new products; and trade capture from the front to back office.

"Financial institutions understand the crucial value of transparent pricing policies, but the obstacle is effectively implementing a consistent policy throughout the organisation to foster transparency," says Steven O'Hanlon, president and coo at NumeriX. "Organisations must use industry-standard analytics and proven models to create a foundation for an enterprise pricing policy. It is the only way institutions can manoeuvre the current market volatility and remain confident in their portfolios."

The paper also advises on the importance of high-quality data for a robust enterprise pricing policy. It is critical for financial institutions to ensure that data used internally is the same data seen by counterparties, risk managers and administrators, as well as auditors, the two companies say.

This will eliminate inconsistencies in reporting and, moreover, enable better back-testing strategies that are critical to confirm accuracy before bringing instruments into the market. To enable this transparency, valuation providers need to ensure that services are agile enough to allow fund managers to provide accurate and timely valuations, regardless of the complexity of the financial instrument.

"The quality of data being used within an organisation dictates its ability to create accurate and timely valuations, particularly with complex derivatives that are inherently difficult to value. If there is poor data flowing into a valuation system, there will be inaccurate data going out into the market," comments Laurent Paulhac, ceo of CMA. "In partnership with NumeriX, we have a better understanding of how clients use valuation systems in conjunction with our data and, ultimately, help investors remain competitive in a challenging market."

Credit risk remains at historically high levels
Despite a marked drop in credit spreads and equity market volatility in the past two months, credit risk remained at historically high levels in January 2009 as measured by Moody's Gap Dispersion Index (GDI). The GDI edged up to a record 3.82 in January 2009, from 3.79 in December 2008.

January's GDI belies the views of the bond and equity markets that aggregate credit risk has subsided in recent months, according to Moody's. Its research has found that changes in the GDI have historically led movements in other measures of credit risk, such as credit spreads, the VIX and ratings changes by about two quarters.

Although the persistently high level of the GDI indicates that risk remains at historic levels, there are signs that it may be starting to plateau. Credit spreads have already climbed to unprecedented levels, pricing in Depression-like assumptions about default rates.

Bond and CDS spreads appear to have therefore already priced in a worst-case scenario with respect to aggregate credit risk. Moreover, the high yield default rate is a lagging indicator; by the time it peaks, credit risk has already subsided considerably.

Given the relatively strong correlations and long leading relationships between Moody's GDI and credit spreads and volatility, it is unlikely that recent improvements in spreads will be long lasting; over the near term, Moody's expects that they will fluctuate in a range between year-end 2008 and current values.

"If the historical correlations hold up, a sustained decline (lasting about six months) in the GDI will provide a strong signal that spreads, volatility and downgrades/defaults will reverse course and take a downward trajectory," the agency concludes. "As of January, we see no signs that a peak has yet been reached; we may trudge along the plateau for several more months."

ABS CDO liquidated ...
The portfolio collateral of Midori CDO has been liquidated. The transaction is a hybrid ABS CDO collateralised predominantly by mezzanine classes of RMBS.

The deal experienced an event of default (EOD) and the controlling noteholders subsequently voted to liquidate the collateral in the transaction. A notice from the trustee says that the portfolio assets have been liquidated and the available proceeds have been distributed to the noteholders.

As per the final payment date report on 31 December 2008, the cash balance available after liquidation was insufficient to pay down the balance of any of the notes in full. Lehman Brothers Asset Management was collateral manager on the deal and the arranger was Bank of America.

... while further downgrades are made
Moody's has downgraded its ratings on a further 151 notes issued by 31 CDO transactions, consisting 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 (see also last week's issue).

EMEA ABCP market shrinks
Issuance of EMEA ABCP declined by 26.7% year-on-year, recording a total issuance volume of US$252.29bn at the end of December 2008. According to a new report from Moody's, this decline indicates a continuing lack of confidence on the part of investors due to turbulent and unpredictable economic conditions. Moody's outlook for ABCP ratings is currently negative.

Moody's expects the general deterioration of global economic conditions in 2009 to generate increasing pressure on counterparty ratings and on the performance of certain asset classes. However, these circumstances will be mitigated by conduit sponsors' ability to employ various structural solutions and risk management strategies to deal with the challenges. The situation may also be improved by the interventionist measures that have been introduced by central banks and governments in EMEA and the US.

Moody's predicts that issuance levels for the sector will decline slightly during 2009, although it cautions that this is predicated on the current schemes, which have been established by central banks and governments, being maintained or replaced at their expiry.

WBS criteria updated
Fitch has updated its criteria for whole business securitisation (WBS) ratings, replacing the existing criteria published on 28 January 2004. The agency's criteria report provides greater detail on the various steps in its rating methodology, notably its analysis of the business and structural characteristics of the WBS issuers.

The scope of the updated criteria has been limited to WBS whose secured creditors, as the holders of qualifying floating charges, benefit from the ability to appoint an administrative receiver, as stated by the UK Enterprise Act 2002. Absent this ability, Fitch will assess whether the legal or structural framework is suitable for applying part or all of its methodology.

Fitch's approach continues to be operational cashflow-based, with the assumption that WBS issuers have stable historical and predictable future cashflows founded on high entry barriers, sound industry fundamentals and low-risk strategies. The agency does not anticipate the release of the updated criteria to affect the current ratings of WBS transactions.

Enhanced structured finance workstation revealed
Moody's Analytics has enhanced its Structured Finance Workstation (SFW) platform by integrating macroeconomic forecast data from Moody's Economy.com and credit risk modelling from Moody's Mortgage Metrics with the platform's existing cashflow analytics tools.

"Investors can now access integrated economic forecasts, credit risk modelling and securities valuation through a single platform," comments Jacob Grotta, md of Moody's Analytics. "The combination of these services gives investors a powerful and flexible tool with industry-leading analytical capabilities."

The enhanced SFW platform integrates macroeconomic forecasts from Moody's Economy.com within the Moody's Mortgage Metrics model to generate constant prepayment rates (CPR) and constant default rates (CDR) based on individual loan characteristics. The corresponding CPR curves and CDR curves feed directly into SFW, which combines the waterfall with loan-level data to generate cashflows and valuations for the entire capital structure or a single tranche.

"These enhancements are a direct response to our clients' desire to include macroeconomic forecasts when analyzing structured finance transactions," commented Mark McKenna, Director of Moody's Analytics. "The addition of economic and credit forecasts will allow for a more rigorous analysis of asset-backed securities."

Historical high for credit card delinquencies
Fitch says that delinquencies among UK credit card trusts hit a new historical high in December 2008. This, together with the continued economic deterioration in the UK and the latest reported increases in individual voluntary arrangements (IVAs) and bankruptcies, are factors underpinning the agency's negative outlook for the sector. The agency expects further deterioration in performance through 2009.

In its 'Credit Card Movers & Shakers (UK) - Q4 2008 Performance' report, Fitch details how the agency's index of 60-180 day delinquencies (Fitch DI) increased through Q408 to 4.3% in December from 3.8% in September 2008. This marks a historical high for the index and reflects many more consumers struggling to make regular payments on their credit cards in recent months.

"Although the increased delinquencies have been expected in the current difficult economic environment, the magnitude and speed of deterioration, together with these latest increases in the IVA and bankruptcy filings are concerning trends," says Steven Webber, associate director in Fitch's European structured finance group. "Due to these factors and the wider economic difficulties facing UK consumers, our expectation is for further performance deterioration amongst UK credit card ABS in 2009."

Between September and December 2008, each of the trusts included in the index, with the exception of Cumbernauld, reported increasing delinquencies and charge-offs. The Fitch Charge-off Index (Fitch CI) rose to 7.2% in December 2008 from 6.6% in September 2008. While the improvements in performance of the Cumbernauld trust display a trend which suggests out-performance of the market, Fitch notes that recent changes to the debt management programme operated by Barclays could have influenced part of this improvement.

The Fitch Monthly Payment Rate Index (Fitch MPRI) has fallen between September and December to 16.1% from 17.2% and, while this performance indicator is typically more susceptible to monthly variation - especially at the turn of the year - Fitch has noted for some time how payment rates could come under pressure if cardholders start to experience increased difficulty making repayments. At present, the CARDS I, CARDS II and Pillar trusts all have a three-month average MPR below their respective Fitch base cases.

Both the Fitch Yield Index (Fitch YI) and the Fitch Excess Spread Index (Fitch ESI) declined through Q408; the Fitch YI fell to 20.6% from 20.9% and the Fitch ESI to 6.1% from 6.6%. While these falls also present a concern, both indices continue to hold good and reasonably stable performance. With increases in charge-offs expected, however, together with pressure on credit card originators to restrict increases in the rates charged on credit cards, the agency expects pressure on excess spread through 2009.

Most junior notes of UK credit card ABS transactions have already been individually assigned a negative outlook, suggesting the likely direction of any rating change over the next one to two years would be negative.

CS & AC

CDS

CDS market changes

Bradley Rogoff, high yield strategist at Barclays Capital, expects the changes taking place in the CDS market to make corporate derivatives simpler and more efficient

Despite a plethora of negative headlines, the corporate CDS market has remained remarkably liquid following the Lehman Brothers bankruptcy. While there was certainly a slowdown in trading in late September as market participants coped with replacing trades that faced Lehman, the subsequent revival surprised even the market's most ardent supporters.

The government's support of the remaining dealers certainly inspired confidence that another large counterparty default was unlikely. In addition, we believe investors became more comfortable with derivatives, knowing that greater regulation was on the horizon.

The goal of trading through a central clearinghouse proved unrealistic by year-end, but with promises having been made to the Fed by the dealer community, this change looks set to occur for at least a part of the market by 20 March. Four entities are competing to clear trades, including Intercontinental Exchange (ICE), CME Group, Eurex and NYSE Euronext's Liffe. By far the most details have emerged from the ICE proposal and, with dealer support and the advantage of being the first to market, it appears to be the front runner to clear the majority of trades in North America.

In the rest of this article, we discuss the changes necessary to simplify the CDS market in order to trade through the clearinghouse, including differences in accruals, effective date, coupons, auction procedures and triggering events. While these changes may cause some initial inconveniences, in the long run they should make the corporate derivatives market much simpler and more efficient (Figure 1).

We do not believe that a central clearinghouse is the full solution to the counterparty risks that exist in the derivatives market today, as clients will eventually look for segregated margin accounts. However, this is the initial and biggest step that needs to be taken in order to remove systemic risk from the CDS market. According to DTCC data, dealer-to-dealer trades represent more than 80% of CDS transactions (although this number is artificially high because of prime brokerage arrangements), and the lack of counterparty risk for these trades will be a significant positive for the market in general.

While dealer posting requirements for initial margin have not been established yet and will vary based on offsetting trades, the fact that dealers will be posting initial margin for the first time should also continue to deleverage the system. This should have a broader effect on the market, as removing some of the leverage advantages in CDS and removing a great deal of the counterparty risk should help with the normalisation of the cash/CDS basis.

The central counterparty solution has taken a while to get off the ground, but now that the launch appears imminent, a full roll-out is key. We believe it is extremely important that the move to clearing single name trades, off-the-run CDX and possibly iTraxx follows closely on the heels of the initial clearing of on-the-run CDX transactions.

In addition, the lack of a global solution is somewhat disappointing. To date, the European Commission has focused on a separate European-domiciled regional clearing solution, despite the global capabilities of the proposed North American clearinghouses. The downside is that it will not allow for a full picture of risk from the dealers facing the clearinghouse.

Finally, we must address the proposed legislation by Representative Peterson that seeks to regulate OTC markets. We commend Washington for attempting to hasten the process toward clearing, but believe the bill makes little sense, as it could destroy liquidity and paralyse trading in the entire US$684trn OTC market.

The treatment for CDS is the harshest, as the legislation seeks to ban naked buying of contracts. This would essentially halt all trading, as counterparties would no longer want to sell protection, even to entities that own the bonds of a reference entity, since dealers probably do not own the underlying as well and couldn't hedge themselves by buying protection from a different counterparty.

We believe the bill shows a lack of understanding of the essential nature of CDS in the credit creation process and that the corporate CDS market is vastly different from the bespoke products that were used in the mortgage market and caused the demise of AIG. Section 16 of the bill is also ambiguous in that it states, "it shall be unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs". Do participants need to own the underlying?

Can they own a smaller portion of the underlying than their CDS positions? What if they owned the underlying when the contract was entered and subsequently sold it? We believe that the consequences of such a bill could be disastrous for the capital markets; therefore, we place a low probability on its passing in its current form.

The major changes
In order for CDS to be cleared efficiently, a number of changes are being made to standardise the product. Some will be seamless and have little effect on the average investor. Others could have significant effects, depending on the counterparty and the quality spectrum of the product being traded.

We summarise the following key changes:

1) Hardwired auction settlement
2) Removal of the restructuring credit event
3) Standardised fixed coupons
4) Effective dates
5) Accrual dates.

Importantly, we note that, while we expect these changes to be implemented, none are fully set at this time, and there may be minor tweaks prior to 20 March. In addition to these changes, the possibility of removing reference obligations has been discussed, although it appears unlikely to occur next month. This would have little practical effect, as a trade that formerly had a senior unsecured reference obligation would trade at the senior unsecured level under the same reference entity.

There will also be a rules supplement to the credit derivatives definitions for corporate CDS trades that will add language concerning auctions and dispute resolution under which trade participants will be bound. The resolution process will be run through the ISDA Determinations Committee, which will include major dealers and have significant buy-side representation. The current proposal is for a fifteen-person committee, with ten CDS dealers and five buy-side investors.

Hardwired auction settlement
The major step that investors will have to take ahead of the implementation of the rules supplement is signing up for a protocol that converts old trades to include the supplement and agrees that old and new trades will be subject to the current CDS auction process. The adherence period for this 'big bang' protocol should be open during the first two weeks of March.

If counterparties do not sign up, they will likely face diminished liquidity and may not be able to trade with certain dealers that do not wish to manage the auction basis risk. This one-time sign-up will also save all participants from having to sign up for a new protocol following each default.

We believe that virtually all market participants will sign up for the 'big bang' protocol, as prior auctions have proved to be efficient mechanisms for settling trades. Those that own bonds as part of a basis trade and wish to effectively physically settle their trades can easily do so through the auction, as they will get the same clearing price for the CDS protection they bought and for the bonds they sell into the auction. Sellers of protection that wish to establish a position in the bonds may continue to do so by placing physical settlement requests to buy bonds in the first phase of the auction.

We also note that the auction protocol has been hardwired into the LCDS and LCDX contracts for some time now. It is likely that there may be slight changes for these products in the future to bring them in line with the changes to the unsecured CDS market.

Removal of the restructuring credit event
One action that should be seen as a significant positive in the simplification of the CDS market is the elimination of modified restructuring (MR). While there is not currently a solution for historical MR trades, all future North American CDS trades will be done without restructuring (NR).

This is a necessary change in conjunction with the hardwiring of the auction. If a CDS is triggered because of a restructuring and it has numerous bonds with different maturities, as many as 40 auctions may be necessary to settle all the contracts because of maturity limitations on deliverables (Figure 2).

While the Determinations Committee will exist to resolve disputes, eliminating restructuring should diminish some of the controversy around credit events. We have had countless conversations with clients about possible triggers from recent debt exchanges and rescue financing (such as GM).

Since the restructuring definition requires an event that binds all holders, it is difficult to trigger; we have not seen a restructuring credit event under the 2003 ISDA definitions and believe it would take a loan maturity extension by an extremely distressed company to actually trigger. Eliminating MR will also remove a source of the CDX versus intrinsic basis that exists because all indices already trade NR.

The downside of removing the restructuring definition is that it will lead to higher capital charges for banks on hedged exposures. On average, banks would lose 40% of the capital relief they currently receive when hedging loan positions with CDS that includes restructuring as a credit event.

US-based banks were hoping to persuade regulators to change these rules, since removing restructuring as a credit event is consistent with regulatory requests related to hardwiring the auction. However, they have been unsuccessful to date and, as a result, all banks will have higher regulatory capital charges for positions that they hedge using the new format. While capital relief changes are still possible in North America, European banks will almost definitely face higher charges.

Standardised fixed coupons
At first glance, the largest change will be that all CDS will trade with standardised coupons of 100bp or 500bp. This will likely be a bigger change for investment grade CDS, as most high yield names already have a 500bp coupon since they trade in points upfront.

The key points for trading with the new contract are:

• Investment grade names should continue to be quoted in spread format.
• Recovery will be fixed at 40% for senior unsecured CDS and 20% for subordinated CDS.
• There will be a broadly published standard converter using the fixed recovery rate for spread trades and a flat curve to calculate the upfront payment associated with a trade.
• Most high yield names will continue to trade points upfront with a 500bp coupon, making the transition seamless.
• While each name will likely gravitate to one coupon, the 100 or 500 coupon can be traded on any credit.

The most significant benefit for investors is that they will no longer face increased bid/offer when they have off-market contracts. While a credit may naturally transition from one coupon to the other over time, dealers will be marking a 100 and 500 curve for each name and should easily be able to execute these switches.

Fixing recovery at 40% and using a flat curve will be familiar to most investment grade investors, as it is exactly how the upfront payments associated with IG CDX are calculated today. We expect IG CDX to have a 100bp coupon just like the underlying investment grade single names and for HY CDX to retain its current 500bp coupon.

The new calculator means the longstanding frustration over agreeing on a recovery rate for single name CDS is no longer necessary. Instead, if dealers believe the recovery is not 40%, they will have to adjust the quoted spread to reflect that difference. While dealers may go through these machinations, investors can just focus on the quote and know that the dealers will stand by this level for unwinds with the same 100bp or 500bp strike.

The reason that dealers will have to be cognisant of where markets are for both the 100bp and 500bp strikes on each credit is that they will be providing daily upfront prices for both strikes to Markit. Dealers will need to pay careful attention to the marking process, because it will determine how much collateral they need to post to the clearinghouse on each trade.

The availability of this pricing information should be another major positive as market participants seek to increase transparency in response to the negative press about the opaqueness of CDS. This follows the release of weekly data by DTCC since November that provides the market with outstanding gross and net notionals for individual names and CDX indices. More recently, DTCC has also provided weekly data on new trades, unwinds and terminations for the indices and at a sector level for single names.

Each week, the DTCC data have shown that gross notionals are declining. While a part of the decline may be as a result of unwinds in a given week, the majority is due to the tearing up of offsetting dealer trades through compression mechanisms. While these efforts have had a positive effect so far and led to the elimination of US$30.2trn in notional, according to TriOptima, they should be much improved under the new contract for the following reasons:

• All trades will have the same effective date.
• There will be no MR/NR basis.
• Trades will only have a 100 or 500 strike.

The last point is by far the most important. Since legacy trades almost never have the same strike, the scope of compression was limited under the existing contract. However, with 100/500 strikes, dealers can re-coupon each of their pre-existing NR trades to a trade with a 100 strike and a trade with a 500 strike.

As can be seen in Figure 3, there is a unique solution for each original strike. The two trades have the same convexity, running spread and jump-to-default profile as the original trade.

Initially, this doubles the number of trades. However, for dealers that never get to call a counterparty to unwind, numerous offsetting trades will be apparent after the re-couponing.

As a result, we expect gross notionals to decline materially after the first compression runs. The obvious next step would be a re-couponing and compression process for non-dealers.

Since buy-side investors have the ability to unwind contracts, this process would likely not have as large an effect in decreasing gross notionals (Figure 4). However, investors will likely find it attractive because it will ensure they do not have off-market strikes when they unwind trades. While we expect liquidity to remain fine for off-market legacy trades in the near term, over time it may diminish.

Effective dates
Despite being less important for day-to-day trading, standardising effective dates will benefit the market as compression becomes easier and trade populations are netted. The current proposal is for the effective date to be rolling on each trade as the current dateless 60 days.

In other words, the effective date on a trade done on 23 March would be 23 January. Then on 24 March the effective date for that trade would become 24 January. This compares with current procedures in which the effective date is the day after the trade is done and remains that date for the life of the trade.

Another advantage is that this provides a look-back period for succession and credit events. A prime example is Bank of America's assumption of Countrywide's debt.

This eventually led to a full succession event for Countrywide CDS, but the debt assumption did not become clear to the market immediately. The new effective date proposal allows a 60-day look-back to discover any similar transactions.

Accrual dates
Another accounting modification is the move to change accrual dates from T+1 to the previous quarterly coupon. Practically, this means that the seller of protection will make a payment at trade inception and receive a full coupon on the next payment date, as opposed to the short first coupon they currently receive.

For example, a trade done on 1 April will result in a payment from the seller of protection to the buyer for accrued from 20 March to 1 April, then the seller will receive a full coupon on 20 June. In this sense, CDS will be similar to bonds. However, unlike bondholders, sellers of protection will, of course, still receive their accrued up until the trigger date if there is a credit event.

Conclusion
Over the past few years, the CDS market had become somewhat of a victim of its own success. Having grown exponentially, it also branched off into more customised areas that deviated from the basic purpose of the market.

At its core, the corporate CDS market provides an efficient measure for banks and investors to hedge pure credit risk and, therefore, increase lending. At a time when the government is desperately seeking a way to boost lending, we believe shutting down the CDS market would be a substantial negative for corporate lending. Instead, the move to a more regulated and centrally cleared system should achieve the goal of increasing transparency and deleveraging the market.

© 2009 Barclays Capital. All rights reserved. This Research Note is an extract from 'US Credit Alpha', published by Barclays Capital on 6 February 2009.

Trading

Trading ideas: steel toe boots

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on United States Steel

From the basic materials sector, we highlight US Steel as a crossover credit to get long. While we are certainly not bullish on US Steel's industry whatsoever, we believe the company is in a position to withstand economic turmoil and its credit spread overcompensates for the downside risk.

The company reported decent 2008 earnings last month and seriously played up negative expectations for next quarter. The company maintains roughly US$3bn in total long-term debt, with US$724m in cash in hand and more than US$500m in available credit facilities. The company's credit spread currently trades upfront and provides investors with significant carry to withstand possible spread widening.

Our biggest concern is an absolutely disastrous first quarter, wiping out both its liquidity and any sort of free cashflow. We will keep a tight leash on this trade, especially as we near the company's earnings announcement date, 29 April.

We see a fair spread of 300bp for US Steel based upon our quantitative credit model. The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit).

US Steel's interest expense, liquidity, margins and free cashflow are all strong relative to peers. However, we recognise that these factors are backwards-looking and will likely deteriorate over the next quarter.

With that being said, we still believe its current spread level is too wide. Our credit model turned bullish on US Steel's credit spread in September as the credit market was shocked by the Lehman bankruptcy. Exhibit 1 shows a time series of US Steel's spread and expected spread, and the current difference remains substantial.

Exhibit 1

Sell US$10m notional US Steel Corp 5 Year CDS protection at 10.0% upfront plus 500bp running.

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).