Contents

CLOs

Concentration risk

Investors prompted to reevaluate portfolio overlap

The marked acceleration in credit quality deterioration so far this year has prompted investors to reevaluate portfolio overlap across European CLOs. Indeed, market technicals are expected to be determined by whether CLOs become forced sellers, as well as by who becomes the marginal buyer of these deals.

Portfolio loss is a function of portfolio overlap, according to JPMorgan CDO analyst Rishad Ahluwalia. "Overlap drives risk across tranches and managers," he says.

JPMorgan CDO analysts recently analysed the impact of Belvedere and Martinsa Fidesa - two of the few loan defaults experienced in Europe so far - on CLO portfolios: a small number of transactions suffered losses but these were spread across several different managers, so the analysts weren't able to determine a pattern. But in terms of the broader European CLO universe, the top 20 to 30 most concentrated names appear commonly across deals - although more dispersion is visible among smaller companies.

Furthermore, in a sample of 184 European CLOs that it rates, a recent analysis undertaken by S&P shows that the top 35 obligors each appear in more than half of the portfolios. An average pair of transactions was shown to have 28% of their portfolios in common.

"So far there has been some performance tiering between transactions, but it is early in the cycle and we would expect increasingly more correlated performance, given the unprecedented weakness in credit," observes Ahluwalia. "What is by now clear, however, is that - as with the sub-prime market - technicals in the corporate CLO sector really do imply negative fundamentals. What we're seeing at the moment is probably a rational indicator of the extent of losses that are likely to hit the European CLO market, with this tiering in mind."

Indeed, indicative secondary market valuations for triple-B CLO tranches are currently at around 8-10c, reflecting the likelihood of principal impairment. But at the double-A and triple-A levels investors appear to be taking longer-term views on the sector and are being constructive in terms of differentiating between transactions.

Such tiering is driven by performance to date, distribution around the triple-C basket, remaining overcollateralisation cushion and concentration of credit-intensive names. CLO event of default language is also expected to play an increasingly important role in determining pricing and relative value across the sector (see Research Notes for more).

S&P confirms that the extent of rising defaults on CLO ratings will, in its view, be coloured by their portfolio characteristics - notably the overlap between different portfolios and concentration risk (which appears to be dominated by TMT and industrial names) within them. "We believe relatively high overlap in the sector means deterioration among a few key corporate obligors could affect a large number of CLOs. However, in this scenario, we generally expect that the severity of any rating effect will likely be mitigated because individual obligor exposures are typically only held in low concentrations."

If the credit risk of any of these obligors deteriorated - or if any defaulted - the effect on CLO portfolios could be widespread, the agency says. For example, a default of the most widely held obligor could have a negative effect on portfolio credit quality in nearly 90% of European CLOs.

S&P has consequently placed 104 tranches of 31 European cashflow CLOs on credit watch negative. So far the review includes two triple-A tranches, five double-As and 16 single-As, with the remainder being triple-B and below.

Ahluwalia says that technicals will be determined by whether CLOs will become forced sellers, as well as by who becomes the marginal buyer of these deals. He notes: "Potential cross-over investors that would typically be looking at the European CLO sector are currently begin distracted by whether CLOs could become forced sellers, the uncertainty around bankruptcy/restructuring in Europe and potentially better opportunities in the US at the moment. Added to this is noise around loan prices and the fact that names which should be avoided happen to be present in many CLO portfolios across the board."

Meanwhile, a growing area of focus for investors is the impact of CLOs on loan restructurings (see SCI issue 121). "This is something that the market hasn't focused on much until recently. In the last cycle CLOs represented only a small part of the market, so this is the first time that securitisations have owned such a large part of the cash market (we estimate that CLOs account for around two-thirds of the European loan market)," Ahluwalia concludes.

CS

Trading

Attractive pricing

Secondary loan improvement fails to attract CLO managers

Prices in the secondary leveraged loan market have, on the whole, been on a tightening trend over the past few weeks. Although a number of highly-rated CLO-friendly names are in some cases now trading above the 80c mark - thereby making them more attractive to many CLO structures - managers remain on the sidelines.

The majority of CLO managers have been reluctant to invest in loans that trade below 80c-85c on the dollar if they want to achieve par value, due to the discounted asset haircut (see SCI issue 109). However, recent S&P LCD data shows that the percentage of performing loans in the S&P/LSTA Leveraged Loan Index bid at or above 80c stood at 30.09% at the end of January, up from 19.44% at the end of 2008. S&P LCD also reports that bifurcation remains the dominant theme in loan-land, with investors bidding up highly rated CLO-friendly names while ignoring more vulnerable issuers, particularly those with a triple-C rating.

But, against this background, most CLO managers appear to be staying on the sidelines. The types of loans that are seeing improved performance come from specific sectors, such as telecoms, and are trading in what is still a very thin market. According to David Matson, md at IKB Fund Management, there are a handful of loan names that are improving price-wise, but it is more than likely that the majority of CLOs will already reference these names.

"Those that don't may see now as an opportunity to buy, depending on the level at which the discounted asset haircut of the deal is set," he says.

Meanwhile, a large number of CLO managers are close to hitting or have already hit their overcollateralisation (OC) triggers, thereby cutting off subordinated management fees (see also separate News Analysis). "We are busy coping with levels of defaults and triple-C buckets and looking very closely at our OC triggers," confirms Matson.

He adds: "However, there's a certain amount of realism coming into the CLO market. If we do trip our OC tests and have to repay our triple-A investors, maybe that's not such a bad thing, given the current credit cycle. It will show the market that CLO structures are working as intended."

Activity in the CLO secondary market remains fairly subdued. Changes to rating methodologies (see last week's issue), defaults and downgrades of loans to the triple-C level continue to weigh on market sentiment.

Although triple-A CLO tranches have maintained a price of around 500bp for a number of weeks, prices for double-A rated tranches and below dropped again last week. On the week, double-A and single-A indicative prices dropped by five points to 30c and 10c on the dollar, while triple-Bs and double-Bs dropped by 2bp to 8c on the dollar, reflecting bid list activity and continued softening in the secondary market.

AC

Documentation

'Big bang' gains momentum

New ISDA supplement expected to bring efficiency and transparency

ISDA circulated a draft of its 'big bang' protocol - through which its new supplement to the 2003 Credit Derivatives Definitions will be incorporated into pre-existing trades - last week, bringing further standardisation of the CDS market a step closer. While the changes proposed in the new supplement may cause some initial inconveniences, they are expected to make the corporate derivatives market more efficient and transparent in the long run.

The new supplement to the ISDA Credit Derivatives Definitions is an incremental improvement and extension of the existing legal framework for the CDS market, confirms Tim Brunne, senior credit strategist at UniCredit. "The proposed changes pave the way for central counterparty clearing, which is the most exciting development."

However, he notes: "Obstacles remain for single name CDS in particular. The difficulties are not related to the legal framework, but rather to efficient and economically reasonable margining models that are also suitable for prudent risk management at the clearing house. Reference prices for illiquid CDS are another issue to be overcome."

The proposed supplement implements six main concepts (see News Round-up for more). At first glance, the most significant aspect of the supplement is that all CDS will trade with standardised coupons of 100bp or 500bp (see last week's Research Notes). This is expected to have a bigger impact on investment grade CDS, as most high yield names already have a 500bp coupon because they trade in points upfront.

Analysts at Credit Derivatives Research indicate that it could be possible to game the 100/500 split on names that are believed to be deteriorating credits but trade in the mid-200bp to 300bp range. One strategy may include gaining duration exposure via arbitraging dealers who quote 100bp and dealers who quote 500bp when the name switches.

Certainly, the closer the current spread moves to either of the 100bp or 500bp strikes, the more liquid it will become. Nevertheless, protection buyers and sellers will be driven by different preferences due to the upfront payments on the contracts, notes Citi head of structured credit strategy Ratul Roy.

Protection buyers will be incentivised to pick the 500bp strike, since it requires the least upfront payment. Protection sellers, on the other hand, should choose the 100bp strike.

"Thus, it is feasible that at any point in time when there are more buyers and sellers, liquidity may move to the higher strike, and move to the lower strike when there are more sellers than buyers," Roy observes. "These dynamics, plus the fact that a price-based CDS market makes it easier to capture trading gains, may make the new CDS contract more volatile than the old form - even after the financial environment has stabilised. Overall, we believe the new CDS has many advantages, but structured trades and the general market will see operational challenges in the short term and possibly greater volatility over the longer horizon."

In conjunction with the hardwiring of credit event auctions, the most controversial aspect of the standardisation efforts has proved to be the removal of the modified restructuring clause from single name CDS contracts (SCI passim). Although it is a necessary step towards being able to clear CDS contracts via a central counterparty, the proposal has split the trading community over the impact it will have on regulatory capital treatment.

Despite the fact that the risk weight for a bank's exposure to the clearing house under the new CDS will be 0% (unlike the 20% that is currently charged for exposure to a high quality bank under a bilateral OTC contract), any advantage is eroded due to the 'restructuring haircut', Roy explains. "Under the Basel 2 rules, banks that buy protection in a contract that does not contain modified restructuring (MR) must discount that protection by 40%. Therefore, banks willing to use the standardised CDS contract may be penalised for doing so and, in the end, just engage in bilateral trades that include modified restructuring."

Roy adds that, given the penalty for not including restructuring, it is possible that a two-tier market could initially develop - one for the standardised CDS and another for OTC contracts that trade on an MR basis. "This is especially true, given the volume of legacy trades," he notes. "While the OTC market surely will continue to exist, its size and liquidity will be eclipsed by the new CDS, and the trend should become more pronounced with time."

The establishment of a CDS central clearinghouse is set to occur for at least a portion of the market by 20 March. So far Intercontinental Exchange (ICE) appears to be the front runner to clear the majority of trades in North America, but CME Group, Eurex, NYSE Euronext's Liffe and more recently LCH.Clearnet (see News Round-up) have also put forward proposals.

CS

LCDS

DIP facility signals low recoveries for Aleris

Markit LCDX dealers have voted to hold an auction for LCDS transactions referencing Aleris International, the latest victim of the freeze in lending. Low recoveries are expected for the name - based on recent experience with Lyondell - given its participation in a DIP facility.

Aleris announced on 12 February that it filed petitions for voluntary reorganisation under Chapter 11 of the Bankruptcy Code in the US Bankruptcy Court in Delaware. The bankruptcy is the latest setback for the US buyout firm TPG after another company it owns, British Vita, signed a standstill agreement with creditors last week. Credit analysts at BNP Paribas note that falling demand and inability to borrow will remain recurring themes for some time, leading to more failures of overleveraged top-of-the-cycle LBO deals.

Aleris has reportedly arranged an 18-month DIP consisting of a US$575m roll-up ABL and US$500m of new money loans. According to S&P LCD, investors who participate in the new loan will be able to roll up their pre-petition debt into a US$500m junior-lien DIP loan on a dollar-for-dollar basis.

Aleris has both US and Euro loans that are currently on the syndicated secured list. It was agreed that the Euro loans would not cross-default in exchange for the right to participate in 5% of the junior-lien DIP. Structured credit strategists at Barclays Capital suggest that, as in the case of Lyondell, there is a high likelihood of low LCDS recoveries because the cheapest to deliver will likely be the loans without rights to participate in new financing.

Interestingly, the strategists note that notional CLO exposure to Lyondell actually increased upon its default. "We believe this increase was likely driven by CLO managers, who bought the old term loans in order to participate in the Lyondell DIP facility [see last week's issue]. DIP loans are likely to be attractive investments for CLOs, given their short duration and attractive coupon levels."

Most CLOs have the ability to buy DIP loans up to a pre-specified maximum threshold. Given the low levels of defaults in the high yield sector through the last credit cycle, these DIP buckets are largely unused inside CLOs.

"DIPs form a large fraction of the forward loan pipeline reported by S&P (around 85%) and CLO investors are likely to be buyers, as long as the DIPs are rated," the BarCap strategists conclude. "We estimate that CLOs currently have about US$3.5-US$6bn of principal proceeds that could potentially be used to participate in the forward DIP pipeline of approximately US$6.25bn."

Meanwhile, Charter Communication is understood to be planning to file for Chapter 11 bankruptcy as part of a financial restructuring on or before 1 April.

CS

Regulation

Merrill bonus investigation gathers pace

New York Attorney General Andrew Cuomo has written to Barney Frank, Chairman of the House Committee on Financial Services, to update the committee about his inquiry into Merrill Lynch's 2008 bonus payments. He alleges that Merrill "secretly and prematurely" awarded approximately US$3.6bn in bonuses.

According to the letter, Merrill Lynch was asked on 29 October to detail its plans for executive bonuses for 2008, including the size of the bonus pool and the criteria it planned to use in determining what bonuses were appropriate. On 5 November the Board responded by stating that any bonuses would be based upon a combination of performance and retention needs. However, Merrill did not provide any details of the bonus pool, claiming that such details had not been determined.

Rather, Cuomo writes: "In a surprising fit of corporate irresponsibility, it appears that, instead of disclosing their bonus plans in a transparent way as requested by my office, Merrill Lynch secretly moved up the planned date to allocate bonuses and then richly rewarded their failed executives. Merrill Lynch had never before awarded bonuses at such an early date and this timetable allowed Merrill to dole out huge bonuses ahead of their awful fourth-quarter earnings announcement and before the planned takeover of Merrill by Bank of America."

The crux of the issue appears to be the potential for a link between the bonus payments and the use of TARP funds. The federal government invested US$20bn in Bank of America's acquisition of Merrill and provided US$188bn in protection against further losses, primarily from the Merrill Lynch portfolio. These investments were in addition to the previous US$25bn in TARP funding that taxpayers had given to Bank of America.

"One disturbing question that must be answered is whether Merrill Lynch and Bank of America timed the bonuses in such a way as to force taxpayers to pay for them through the deal funding," the letter continues. The Attorney General's office now plans to require top officials at both Merrill Lynch and Bank of America to answer this question and to provide justifications for the "massive bonuses they paid ahead of their massive losses".

Indeed, it recently issued subpoenas seeking the testimony of former Merrill Lynch ceo John Thain, as well as the testimony of Bank of America chief administrative officer Steele Alphin. Cuomo expects to seek the testimony of other top executives at the two firms.

His office has learned that, while more than 39,000 Merrill employees received bonuses from the US$3.6bn pool, the vast majority of these funds were disproportionately distributed to a small number of individuals. For example, the top four bonus recipients at the bank received a combined US$121m.

The letter points out that these payments and their curious timing raise serious questions as to whether the Merrill Lynch and Bank of America Boards of Directors were derelict in their duties and violated their fiduciary obligations. "We will also continue to examine whether senior officials at both companies violated their own fiduciary obligations to shareholders. If they did, this raises additional serious issues with regard to the inappropriate use of taxpayer funds," Cuomo writes.

In this context, his investigation continues into whether these bonus payments violated New York's fraudulent conveyance statute and whether the lack of disclosures concerning these payments and other matters violated the Martin Act. "We will also continue to examine the circumstances surrounding any supposed guaranteed bonuses, their justifications and Merrill's obligations pursuant to them, once Bank of America produces more information concerning such bonuses," he concludes.

Separately, RBS has reached an agreement with the UK government as majority shareholder (through UK Financial Investments) on its approach to bonuses for 2008/09. Under the new terms, no bonuses or pay increases will be made to staff associated with the major losses suffered in 2008, and board executive directors will receive no bonus for 2008 performance and no pay increase in 2009.

No discretionary cash bonuses will be paid in 2009 for performance in 2008. Only legally binding guaranteed bonuses will be paid. Total cash bonus payments for 2009 will amount to £175m, reducing the total cash spend by more than 90%.

RBS says that staff who are essential to the bank's recovery and who might otherwise be at serious risk of leaving, but who remain with the bank will receive a deferred award for 2008. The deferred award will be released in three equal annual installments beginning in June 2010 and payable in subordinated debt of RBS (i.e. not in cash).

In individual cases, however, up to 100% of these deferred awards will be subject to forfeiture at the discretion of the Remuneration Committee and if future losses arise in relation to their 2008 activities. Awards will therefore be based on sustained long-term performance, not on short-term revenue generation.

CS & AC

Trading

Unbundling real estate finance

Vlad Krutik, ceo of International Real Estate Securities Exchange (IRESE), answers SCI's questions

Vlad Krutik

Q: How and when did your firm become involved in the structured credit market?
A: The genesis of IRESE was conceived about 2.5 years ago. At that time, a couple of academics (including Harry Markowitz) and I talked about investment opportunities in the real estate market. Specifically, we discussed the leverage that real estate provides and how easy it is to securitise mortgages and sell them on so that at some point someone else holds the paper, yet perhaps doesn't understand or realise its value.

The logic was that if you pool a number of mortgages together, it is easy to trade them. But the current market situation has disproved this theory and now it is even harder to determine values.

The complexity of pricing mortgages has been overblown: we want to remove that complexity in order to address the need for liquidity. We looked at the theory behind trading options in the stock market in order to hedge various risks.

Similar to MBS, options are financial products that have an underlying asset; however, the value of an option is determined by the passage of time based on an index. So we decided to create financial instruments - real estate notes and real estate options - that essentially unbundle the securitisation structure and establish an exchange to facilitate mortgage trading.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: We're targeting property owners and developers, mortgage originators and brokers, and qualified investors. Both commercial and residential property is traded on IRESE.

Q: What is your strategy?
A: A real estate note structure involves breaking a loan into many different interest-bearing notes that represent a fraction of the whole loan. Each note has a face value of US$100, representing one unit of investment, and a variable interest rate that is set by investors at origination. The rate is determined at the time of initial real estate note offer and set by investors, who bid on the offer based on their initial loan risk assessment.

A loan can be profiled by the borrower's credit score, loan-to-value and debt-to-income ratios. Based on investor-defined weighted scores, a specific risk profile receives a score from 1-1000.

IRESE provides all the due diligence the mortgage originator has with the offer, including property owner FICO score range, debt-to-income ratio, loan-to-value ratio, a certified property appraisal and any other additional information provided by a lender. The interest rate on the note is determined through a Dutch auction.

The mortgage owner will be obligated to make monthly payment interest plus principal for a duration of the note or until the property is sold or refinanced. At that point, investors receive the remaining balance of the note principal back. The mortgage owner will continue to be responsible for the customer service, loan servicing and any other loan related activities.

At any time an investor might want to sell the note holdings at the market price. The price is determined by a discount or a premium of the original value of US$100, depending on changes in the risk profile associated with the loan and level of risk free interest rate.

A real estate option, on the other hand, is a contract for a potential payoff at a future date on a predetermined expected value of a specific property. Property owners can sell an option in exchange for debt-free cash or buy an option to limit their exposure to declines in property prices. Investors can selectively buy or sell individual fractions of options based on the future value of specific properties.

A real estate option is not an equity participation or a fractional share of ownership. It is a derivative that is engineered based on the change in value of the underlying asset, a property.

There are two types of options: a real estate call option and real estate put option. The call option property owner can sell an option in exchange for debt-free cash. An investor in a call option benefits from property price appreciation and price volatility.

With a put option, an investor can sell an option and thus underwrite price decline insurance. A property owner, who buys the option, is protected against price decline of the property.

Pricing an option involves a price of an asset, time period and strike price. Option pricing methods require that the underlying asset has a readily available observed market price of any given property at any given time. Since properties are not sold often, IRESE offers a way to derive an observed price of a property based on a weighted combination of publicly available price indices.

These indices are the Case-Shiller Index, the Office of Federal Housing Enterprise Oversight (OFHEO) Home Price Index (HPI) and the Zindex home value index from Zillow, which is publicly available for most properties. By combining the weighted average of publicly available index data, an individual property owner and an investor can find out the value of any property at any given time by applying index change data to the last recorded sale price and sale date for the property. There can be no argument about the value because it is a public index and so can't be manipulated.

IRESE proposes to address moral hazard by allowing the property owner to share only up to 50% of the contract payout. In this case, a limited payout discourages any adverse activities.

Q: How do you differentiate yourself from your competitors?
A: The Chicago Board Options Exchange recently launched futures and options based on the Case-Shiller index (CSI) for largest six metropolitan areas. CSI is a geographical index that is updated every month and captures trends in price changes for a select metropolitan area.

Investors can use the CSI to trade options on a derivative based on observed changes in the value of the index. CSI is an aggregate of the changes in market prices and is focused on the past performance of a regional price change. In contrast, a real estate valuation is location specific.

Our objective is to allow investors to create their own risk profiles and then build the appropriate dynamic pools, as well as to provide them with automated tools to manage the portfolio. We'll alert investors if the risk profile of the mortgages they hold changes, so that they can trade out of the positions if they want. There will always be buyers and sellers for certain risk profiles and/or market makers ready to step in if necessary.

IRESE is innovative because end-users are exposed to the risk/reward of real estate, but don't have to physically buy or sell it.

Q: Which challenges/opportunities does the current financial environment offer your business and how do you intend to manage them?
A: So far we've had significant interest from property developers and mortgage originators, who are interested in price decline insurance so that they won't have to foreclose if they can't refinance, and originators that want to be compensated for any potential price declines. Additionally, we're targeting mortgage brokers that want to add the line item in origination or those who offer reverse mortgages. It's a viable alternative to a reverse mortgage because there are no age restrictions and the borrower doesn't have to give up their home, yet it enables them to tap the wealth built up in their property.

We have CFTC approval to commence trading and we're currently in the process of beta testing with a number of customers. We're also aligning ourselves with a few institutional investors that are looking for alternative investments in compensation for the lack of yield in equities.

Q: What major developments do you need/expect from the market in the future?
A: We've had conversations with the government, but the issue is that the housing crisis in the US is at the trillions-of-dollars mark and the government is looking to simply write a cheque. If you can afford to write a blank cheque, why would you sit down to analyse the fundamental problems in the housing market and try to come up with an alternative solution?

However, throwing new money after old isn't going to clear the system. IRESE is one alternative to help solve the problem, and we continue to explore with the US government how we fit into the rescue plans.

There are option markets for equities and there is no reason why there can't be for real estate, given that the value of the asset changes over time. I anticipate that in five years' time, say, the new issue MBS market will comprise of only government-guaranteed bonds. Alongside this will develop a new market for simpler structured real estate instruments similar to ours that focus on pricing according to risk and dynamic pooling - the alternative just isn't efficient anymore.

Of course, it will be more complicated to develop such instruments for auto loans or credit cards because they don't have detailed data that is publicly available. Nevertheless, there are opportunities to create new instruments that go back to the basics of the underlying assets.

About International Real Estate Securities Exchange (IRESE)
IRESE is the first internet-based, government regulated market where mortgage bankers can securitise their loans, property owners insure against price decline, and investors benefit from real estate price movements and fixed rate of return from diversified fixed income investments. IRESE's website enables members to trade small, inexpensive, easy-to-understand real estate notes and real estate options contracts in international real estate markets.

IRESE is a secure, fully-transparent marketplace, subject to regulatory oversight by the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC).

CS

Manager hires structured credit veteran

The latest company and people moves

Prytania Investment Advisors has hired Paul Levy as a partner, as the firm expands the scope of risks it evaluates and advises upon. Levy comes to Prytania with eight years of experience in structured credit at Morgan Stanley, Deutsche Bank and Merrill Lynch. In his new role he will focus primarily on assisting Prytania's clients in managing the risk in their structured finance and credit portfolios, some of which are managed directly by Prytania.

Charles Pardue, Prytania's managing partner and head of risk advisory, says: "As we continue to expand the scope of risks we evaluate and advise upon, Paul brings a wealth of experience, particularly in investment grade synthetics, where we are seeing an increase in activity. Clients will benefit from his in-depth knowledge, given Paul's integral role in the development of the credit derivatives market over the past eight years."

"One of the outcomes of the credit crisis has been the return of focus on core credit risk management skills, which plays to our strengths," adds Malcolm Perry, Prytania ceo. "We expect this trend to continue for some time and for it to be a key driver of both our asset management and risk advisory businesses throughout 2009."

Lepone resigns
Robert Lepone, head of European distressed and leveraged credit trading at Morgan Stanley, has resigned. He is leaving the bank for personal reasons, according to a bank spokesman.

Broker moves into ABS
Amherst Securities, a broker-dealer specialising in RMBS, has hired four new team members to expand its reach in securitised products. Joining the firm are Daniel Farrell, senior md, structured products group; Mark Castiglione, md, structured products group; Andrew Beal, md, agency CMO trading; and Kenneth Dinovo, svp, agency CMO structuring and trading. These additions to the Amherst team will allow the firm to increase its reach in the mortgage space and expand its securitised product offerings to include ABS and structured transactions.

Farrell will help develop Amherst's non-mortgage ABS and structured finance business, expanding Amherst's existing platform. He joins from MatchPoint, which he co-founded, having previously worked as group head of the structured asset finance group at Wachovia Securities.

Castiglione will work closely with Farrell. He was previously at R3 Capital Management, a multi-strategy credit-focused hedge fund, where he managed a portfolio of off the run ABS.

Beal previously worked at Merrill Lynch for 12 years, where he traded CMOs with a focus on secondary and new issue fixed income and derivatives. Dinovo will work with Beal to build up Amherst's CMO business. He previously worked at Merrill Lynch in agency CMO trading and as head structurer.

Manager increases CDO count
Deerfield Capital Management has been appointed as replacement collateral manager for Mayfair Euro CDO I by the controlling class investor. The Mayfair CDO is collateralised primarily by euro-denominated investment grade and high yield corporate bonds. As of 15 December 2008, the aggregate principal balance of the Mayfair CDO was approximately US$117m.

Deerfield last year announced plans to take on further CDO management contracts when it took over Robeco CDO II in July. According to Jonathan Trutter, ceo, Deerfield was able to assume the entire ongoing management fee stream for Mayfair CDO without the payment of any purchase price to its prior manager, and without entering into any fee sharing arrangement.

The previous manager was Muzinich. Including the Mayfair CDO, Deerfield now manages 28 CDOs.

Another bank writes CDOs down to zero
The Bank of East Asia has become the latest bank to write down its CDO holdings to zero. The bank has announce profit after taxation of HK$104m for the year ended 31 December 2008, 97.5% lower than the HK$4,221m reported in 2007.

With the continuing deterioration of the credit markets, particularly in the second half of last year, BEA took decisive action in October 2008 to sell or write off its entire CDO holdings. "We enter 2009 with a clean slate," says David Li, chairman and chief executive of BEA. "With the CDO portfolio off our books, we have no further exposure to the troubled assets that continue to weigh on many banks worldwide."

Belgian bank KBC wrote down its mezzanine CDO investments to zero last month, retaining only the super senior tranches (see SCI issue 121).

Analysts at Credit Derivatives Research suggest that the market is pricing in a lower probability of any over-paying bank bailout bill (given bank widening and ABX/CMBX underperformance), with the reality being that "the banks will have to write their ABS CDO valuations down to zero soon enough".

Monoline restructures, exits CDS business
MBIA has established a new US public finance financial guarantee insurance company within the MBIA group by restructuring its principal insurance subsidiary, MBIA Insurance Corporation. As part of the transformation, the stock of MBIA Insurance Corp of Illinois, a public finance financial guarantee insurance company, was transferred by MBIA Corp to a newly established intermediate holding company - which is itself a subsidiary of MBIA. MBIA Insurance Corp of Illinois is expected to be renamed National Public Finance Guarantee Corporation.

MBIA intends to operate its municipal business as a separate operating and legal entity that will have no exposure to structured finance business. Jay Brown, chairman and ceo of MBIA, states that ultimately MBIA intends to be back in the structured finance and international markets, but it will maintain strong operational and legal separation between those businesses and the US public finance business.

In a letter to MBIA owners, Brown also says that MBIA will no longer use credit derivatives to guarantee new insurance transactions. "Our exposure to this market injected entirely too much volatility into our financial statements, which had the unfortunate effect of reducing confidence in our financial strength," he says.

Permacap set to invest in senior CLO tranches
Permacap vehicle Carador will ask its shareholders at an Extraordinary General Meeting on 9 March to approve a proposed change to its investment objective and investment policy to permit investment in the senior notes of CLOs.

The current investment objective of the company is "to produce attractive and stable returns with low volatility compared to equity markets by investing in a diversified portfolio of equity and mezzanine tranches of CDOs". The investment manager believes that in the current market environment senior notes, as more senior tranches in the CDO structure, may provide an attractive return with a lower risk profile.

The directors of the company have also announced that they intend to consider conversion notices received ahead of the quarterly NAV calculation dates.

Unwise hedging decisions led to CAM downgrade
Fitch has downgraded Collineo Asset Management CDO Asset Manager Rating (CAM) for structured finance to CAM4 from CAM3+. The downgrade is primarily driven by hedging decisions taken by Collineo relating to two of its CDOs that, in Fitch's opinion, appeared to have been to the detriment of senior and mezzanine noteholders.

Fitch views these actions as not being consistent with those of a CDO manager with a rating in the higher rating categories and has accordingly downgraded the rating to a level it deems to be appropriate, given the actions taken by Collineo. Absent these actions, Fitch would have considered Collineo as an adequate CDO manager, it says.

Additional considerations include challenges, such as: business risks and operational challenges associated with executing a new business strategy in the current market context; a technology platform that is falling behind Collineo's peers; increased key person dependency on the ceo, following senior management departures and mitigation of losses to investors in US-exposed CDOs; and managing European CDOs through a period of stress.

However, while Collineo's business franchise was adversely impacted by the credit crisis, Fitch views Collineo's recent purchase by Sal. Oppenheim jr. & Cie. KGaA as a positive, as Collineo found an acquirer that may provide the support needed to ensure the firm's longer-term viability. Additionally, Collineo remains one of the largest ABS CDO managers in Europe, which contributes to a larger fee income stream, adds Fitch.

Structured finance lawyer promoted
Sheppard, Mullin, Richter & Hampton has promoted eleven of its attorneys to partner. Among these is Seth Kim, a member of the firm's finance and bankruptcy practice group based in New York.

Kim specialises in commercial law, bankruptcy, bank regulatory matters and bank acquisition transactions, including commercial lending transactions, asset-based finance, commercial paper, asset securitisation, swaps, options and OTC derivatives, total return swaps and other structured derivative programmes.

NAV decrease for permacap
Queen's Walk Investment Ltd reports that, as at 30 September 2008, its NAV was €4.95 per share - down from a NAV of €6.32 per share, as at 30 June 2008. The decrease in NAV reflects the expected deterioration in the UK and continental European mortgage markets in the company's cashflow forecasts, as at 30 September 2008.

In the quarter ended 30 September 2008, the company estimated cashflows for the December quarter of €7m (using 31 December 2008 FX rates). Actual cashflows recorded in the quarter ended 31 December 2008 were €7.8m.

The company had a net cash balance of €9.3m as at 12 February 2009 (following payment in January 2009 of €2.1m for the September 2008 dividend, €1m for the purchase of a partial option hedge against the MDAX index and payment of €5.5m to reduce the principal of its financing facility). Following the repayment of €5.5m of the facility, the current outstanding amount of €29.5m is already significantly lower than the agreed target loan amount at 31 March 2009 of €33m.

Credit-X integration announced
Markit and RiskVal Financial Solutions have announced the integration of Markit's pricing and reference data into RiskVal's Credit-X trading platform. The platform has integrated a broad array of Markit's products and services, including Markit RED for CDS and LCDS; Markit Quotes; Markit Intraday; Markit Indices; and Markit's CDS and LCDS spread services.

Markit says its alliance with RiskVal has created a trading platform that delivers improved risk analysis tools, including real time profit and loss management, more accurate data entry and superior credit event management. Credit-X is available as a remotely managed software as a service (SaaS) or as an enterprise solution.

AC & CS

Credit Derivatives Definitions gain clarity

A round up of this week's structured credit news

Further details emerged last week about the proposed supplement to the 2003 ISDA Credit Derivatives Definitions, the implementation of which forms part of the industry's effort to further standardise the credit derivatives market and to increase transparency. According to lawyers at Schulte Roth & Zabel, the supplement will fundamentally change the way in which CDS trade and operate by addressing critical market issues, such as how to determine whether a credit event has occurred and what obligations may be delivered (see also separate News Analysis article).

The proposed supplement implements six main concepts: a committee of rotating ISDA members (the Determinations Committee) for each region that will determine the details of each credit event and succession event; a 60-day 'look-back' limitation on the determination of credit events and succession events; a new 'hardwired' auction settlement method based on ISDA's recent credit derivative auction protocols; standard quarterly payment dates and accrual periods for fixed amounts under all credit default swaps; changes to the determination of the currency exchange rate for physical settlement; and a new method to accelerate the physical settlement process for loans.

Under the proposed supplement, a Determinations Committee will determine the type and date of credit events; the date of a valid notice of publicly available information; the date of receipt of a credit event notice; what obligations constitute deliverable obligations; and what obligations constitute substitute reference obligations. The Committee will also decide whether to hold an auction to settle the related CDS transactions and will control the terms of and participation in the auctions.

Each regional Determinations Committee will comprise eight global dealers, two regional dealers and five buy-side members. The criteria for membership of the Determinations Committee - like the rest of the proposed supplement - are subject to further discussion.

However, under the current draft, preference will be given initially to dealer members with the largest notional trade volumes. For buy-side members, each must have at least US$1bn in assets under management and US$1bn in notional single name CDS. Additionally, the group of buy-side members must contain at least one hedge fund and at least one traditional asset manager.

The proposed supplement changes all fixed rate payment dates to 20 March, 20 June, 20 September and 20 December. Fixed amounts will begin to accrue on the quarterly payment date on or immediately prior to the trade date, meaning that protection buyers will pay for protection from prior to the trade date, with credit events and succession events that occur prior to the trade date affecting the trade. Additionally, the currency rate for each deliverable obligation will be locked in and determined for each updated deliverable obligation based on the one that it replaced.

Finally, the proposal allows parties to voluntarily compress the physical settlement process for loans - in other words, skip the intermediate parties and deliver the loan directly to the ultimate protection seller. The intermediate parties will then settle their respective back-to-back trades through cash settlement.

ISDA expects to publish the final version of the supplement and to offer the big bang protocol for adherence on 2 March in preparation for the roll of the CDS indices.

CDS notional rises
The latest DTCC data shows that CDS volumes have grown on the week: total gross notional rose 2.33% to US$28.1trn as 17,775 contracts (and US$641bn of gross notional) were added. Analysts at Credit Derivatives Research (CDR) note that this is a significant change from the recent trend and perhaps reflects a bottom in terms of short-term unwinds in the CDS markets.

Index trades accounted for the largest addition of risk in both percentage and absolute terms (4.58% and US$450bn). The CDR analysts suggest that unwinds in bespoke CDOs could be responsible for much of it (as well as general rolling up of indices), as IG9 (the most active tranche-related index) and IG11 increased significantly in both gross and net notionals, while IG8 and IG10 saw gross and net notionals drop week-over-week.

IG9, IG11, XO10 and Main10 saw the largest number of additional contracts on the week (with HY11 trading around a quarter the volumes of IG11). The majority (11 out of 15) of gross notional reductions were for the iTraxx Japan indices, with the rest being CMBX index reductions.

Single names saw only a 0.97% increase in gross notional, but the absolute notional rises of US$138.6bn for single names far outweighs the US$52.4bn rise in tranches. The majority of changes in the gross notionals came from dealer-to-dealer transactions, with indices representing 70% of those transactions. However, end-user to end-user deals rose the most in percentage terms (3.2%), while their notionals remain very low.

The CDR analysts suggest that such risk addition signals a short-term bottom in the tear-up and portfolio compression process. The progress being made towards a CDS central counterparty and contract standardisation (see separate News Analysis) should spur more tear-ups, but these are likely to be roll-related rather than absolute terminations.

Further details emerge on Ferretti auction
ISDA has released further details regarding the credit event auction for Ferretti. In accordance with European LCDS auction rules, Markit iTraxx LevX market makers have determined that Ferretti reference entities (which, in relation to the loans entered into pursuant to the senior and second lien facilities agreement, includes Ferretti S.p.A and Sestante 3 S.p.A and, in relation to loans entered into pursuant to the mezzanine facility agreement, includes Sestante 2 S.À.R.L.) have failed to make payments due on some or all of the loans. The auction will be held for ELCDS transactions referencing any loans that constitute reference obligations either pursuant to the LevX Senior or Subordinate indices.

Euro CLO ratings impacted
Fitch's decision to downgrade 11 European leveraged loan CLOs and place 94 CLO tranches on outlook negative on 12 February means that 43% of Fitch-rated European leveraged loan CLO tranches have now been downgraded or placed on outlook negative since the agency's updated criteria for all corporate CDOs, including CLOs, was published in April 2008. Approximately 99% of the rating actions have been on tranches rated single-A and below, with the vast majority of the downgrades affecting double-B or single-B rated notes.

The rating actions reflect the agency's credit opinion on the underlying loans in these portfolios. Fitch comments that, if the lower asset valuations and severe reduction in available finance for distressed borrowers now witnessed in the market continue, the credit quality of the triple-B and below rated notes will weaken and this could lead to further downgrades.

Meanwhile, the migration table of rating actions on global CLOs (26 European, 15 US and one Asian transaction) since the revised corporate CDO criteria was introduced in April shows only 2% of triple-A and double-A rated notes have been negatively affected.

Structured credit strategists at Citi suggest that - if the experience with sub-prime RMBS is any example - the market is likely to see further CLO assumption revisions, resulting in downgrades higher up the capital structure. "It is likely that CLO double-As, trading at mid-20bp and junior triple-As at 40bp will not maintain their ratings for much longer. Senior triple-As will also probably see their ratings slashed - although agencies will likely try to postpone the move and will proceed in small steps, suggesting we are at the beginning of a long road of rating revisions in the CLO universe," they note.

However, based on their credit loss modelling work, JPMorgan CDO analysts note that the 'balancing point' for ultimate cumulative losses appears around the single-A to double-A segment of the capital structure. They agree that ratings downgrades and the potential impact on prices remains a "big unknown".

But, they add: "We are sceptical about the prospect of mass forced sales of CLO paper post re-rating. Rather than ratings, we feel selling down of CLO holdings will be driven more by funding/liquidity needs and higher-level business decisions, with the possible exception of bank-held triple-As."

LCH to join CDS clearing party
LCH.Clearnet plans to launch clearing services for CDS in the Eurozone by December 2009, subject to regulatory approval. The service will be managed by Paris-based LCH.Clearnet SA, which is a Eurozone bank and regulated by the Banque de France.

The decision to launch a Eurozone CDS clearing offering is in response to both regulator and market demand, the clearer says. Christophe Hémon, chief executive at LCH.Clearnet SA, says: "We are leveraging expertise from across the group to deliver the benefits of clearing to the Eurozone CDS market. We look forward to continuing to work with the European market to deliver innovative clearing solutions."

Separately, Intercontinental Exchange (ICE) ceo Jeffrey Sprecher revealed during the exchange's annual earnings call that ICE Clear Europe is prepping a European CDS clearing solution.

Fitch introduces loss severity ratings
Fitch has assigned loss severity (LS) Ratings to 472 tranches of 124 Dutch RMBS transactions, the first to be assigned under its new LS rating scale for structured finance transactions. The agency will now be assigning LS ratings to tranches for all new EMEA RMBS transactions that it rates, as well as to rated tranches for existing EMEA RMBS transactions when these transactions next receive a surveillance review. Fitch says the move is the latest in a series of steps being taken to enhance the quality and transparency of its credit ratings.

LS ratings are designed to complement traditional debt ratings and were first proposed by Fitch on 1 July 2008 as part of a wider consultation on three potential supplementary rating scales and indicators for structured finance. The other scales considered addressed rating transition probability and volatility, and collateral quality assessment. In the case of a volatility or transition risk rating applied to structured finance securities, it remains Fitch's view that the analytical drivers to such a rating would overlap significantly with those already addressed by rating outlooks.

"Rating Outlooks are intended to give a forward-looking opinion about the prospective direction of a tranche's rating over the next 12-24 months," says Stuart Jennings, structured finance risk officer for the EMEA region at Fitch. "Fitch believes that they give the market greater information about prospective future individual tranche performance than any potential explicit rating volatility indicator."

In addition, factors that would result in a security being assigned a high volatility rating would also typically be captured by the underlying credit rating. For example, assigning a high investment grade rating would in many cases be incompatible with the type of factors that might lead to a high volatility rating. This would serve as a limit on any potential scale's application.

Fitch's decision, therefore, was not to assign volatility ratings but instead to roll-out rating outlooks globally across structured finance. The agency remains the only one to assign rating outlooks to structured finance securities.

Meanwhile, Fitch's third proposal concerned an explicit assessment/rating of underlying collateral quality. Feedback on this was mixed as to the value of supplementary information that would be provided.

In addition, the agency believes two new scales within a short space of time could create a degree of excess information. Instead, Fitch will enhance the transparency of its credit opinion in this respect through the provision of explicit commentary on collateral quality in its pre-sale and research reports (see below News Round-up story).

Transparency drive for presale/new issue reports
Fitch has launched enhanced presale and new issue reports for global structured finance transactions. The principal aim of the revised reports is to increase their focus on Fitch's opinions with respect to key rating drivers, the agency says.

The reports will include new content that will provide greater transparency regarding how a rating opinion was formed and the impact on such opinion of any changes in key assumptions. The reports also aim to create one consistent template framework across structured finance asset classes, which will aid comparison of risk characteristics across countries and sectors. These changes also reflect widespread industry and regulator comments regarding the need for greater transparency in structured finance transactions.

The revised reports will be adopted throughout the course of 2009, as individual asset class groups finalise the specific content for their area. The first asset groups will start to use new templates for all new transactions from 16 February 2009.

"Fitch's overriding aim for the revised reports is to enhance transparency of the rating opinion. Fitch's view of key rating drivers will be described more succinctly with a greater focus on key areas of discussion during the rating committee. Reports will also describe the data requested and received from originators and how this was used in the analysis," explains Andreas Wilgen, senior director in Fitch's EMEA structured finance team, who coordinated the project to revise the reports. "With increased focus upon model risk in structured finance generally, the reports will describe which models have been used in the analysis, the models' main drivers and any 'out-of-model' adjustments that might have been applied by rating committee."

A new aspect to the reports will be an analysis of the sensitivity of ratings to changes in key rating assumptions. The final form of such analysis will be specified throughout the course of 2009 for the different asset classes.

Example enhancements include an analysis of changes to key assumptions that could result in rating migration from the current note rating. Additionally, a breakeven point analysis will be introduced to identify the maximum stress to a key rating factor (for example mortgage foreclosures for RMBS) a given tranche can withstand without experiencing a default.

Asia Pacific structured credit ...
Fitch has published its outlook report on Asia Pacific structured credit for Q109 and highlights that the varied rating outlook is largely driven by the type of underlying collateral in CDO and CLO portfolios rated in the region.

"Many Asia Pacific structured credit transactions reference global corporates in the form of synthetic investment grade corporate CDOs. For these transactions, the asset performance is declining and the ratings outlook is negative, reflecting the deteriorating credit environment and portfolio exposure to the financial, automotive, building and materials and retail industries," says Kate Lin, associate director with Fitch's structured credit team. While these transactions have generally seen increased ratings stability following the implementation of criteria changes in 2008, credit enhancement levels are thin or non-existent and thus these transactions are especially vulnerable to further defaults in their reference portfolios.

By way of contrast, for structured credit transactions with Asia Pacific assets the asset performance is stable to declining and the ratings outlook is stable. This smaller category of transactions encompasses synthetic balance sheet CLOs, cashflow CDOs of corporates, Japan structured finance CDOs and Taiwan domestic CDOs.

"While some deterioration in the underlying portfolios is expected, these transactions typically have significantly greater levels of credit enhancement, and many have already experienced varying degrees of paydown to the senior notes," says Rachel Stringer, md of the agency's structured credit group.

... and Australian structured finance outlooks released
Fitch says in its special report, 'Australian Structured Finance 2009 Outlook', that asset performance across all asset classes in the Australian structured finance market will deteriorate over 2009. The ratings outlook, however, for most asset classes should remain stable.

"Over 2008, the economy and the underlying assets in structured finance transactions generally performed well. This is set to change in 2009, with Fitch expecting negative GDP growth, increasing unemployment and further falls in property prices - which all leads to deterioration in performance," says Natasha Vojvodic, senior director in the agency's Australian structured finance team.

The aggressive 400bp cut in interest rates by the Reserve Bank of Australia (RBA) will offset some of the deterioration. However, unemployment and the general economy remain the key elements in how structured finance assets will perform.

The Australian government and the RBA have introduced some initiatives over 2008 and the beginning of 2009 to ease the burden of the credit crisis on home buyers and the economy. But counterparty rating actions will also continue to impact the ratings of structured finance assets.

The special report looks at how Fitch expects RMBS, CMBS, ABS and ABCP assets and ratings to perform over 2009. Non-conforming RMBS and CMBS are expected to come under the most rating pressure mainly due to the slowing economy and the rationing of credit by lenders. While the underlying asset performance of conforming RMBS, ABS and ABCP will worsen, the expectation of delinquency and loss levels remaining within rating parameters, as well as transaction structural features, result in a stable rating outlook.

Distressed exchange for CEDO notes
Moody's has affirmed the ratings of three notes issued by the CEDO vehicle and downgraded the ratings of three loan facilities borrowed by CEDO. In addition, the ratings of the three loan facilities will be withdrawn.

The downgrades and subsequent withdrawals, affecting approximately US$84m of debt instruments, are the result of the execution of a termination deed from the 6 February 2009 regarding the loan facilities. Moody's says it views this restructuring as a distressed exchange, which had the effect of allowing the SPV to avoid a payment default at maturity.

CRE CDOs hit by delinquent loan increase
Fitch has placed 28 classes from five different commercial real estate loan (CREL) CDOs on rating watch negative due to an increase in delinquent loans and Fitch 'loans of concern' relative to each class' credit enhancement within its respective transaction. Within the Fitch-rated CREL CDO universe, 21 CREL CDOs contained at least one delinquent loan with individual delinquency rates ranging from less than 1% to 15.2% of the CDO par balance, as of the January 2009 reporting period. After preliminary screening, five transactions, including three that are failing various overcollateralisation (OC) tests due to the presence of these distressed assets, have classes that merit placement on watch negative.

The delinquency rate for the affected transactions ranges from 5.9% to 15.2%. In all cases the percentage delinquent represents at least 70% of the credit support to the lowest rated class. Delinquent loans include loans that are 60 days or longer delinquent and matured balloon loans.

After preliminary discussions with collateral asset managers, Fitch estimates potential expected losses on the delinquencies and any other Fitch 'loans of concern'. In assigning a rating watch negative, Fitch assumed a liquidation scenario by calculating a hypothetical loss for each delinquent loan and Fitch 'loan of concern'. Based on these hypothetical losses, liquidated credit enhancement was determined.

The result was then compared to a base-case expected credit enhancement, which accounts for a transaction's expected loss over the average term of the loans in the pool. If the change between the base-case expected credit enhancement and the liquidation scenario credit enhancement was greater than 30%, tranches were considered for RWN.

Over the next several months, Fitch says it will conduct an in-depth review of the collateral and the liabilities for each CDO under various stress scenarios to resolve the rating watch status.

Meanwhile, 20 newly delinquent loans led to a material increase in US CREL CDO delinquencies to 3.83% for January 2009, up from 2.72% in December 2008, according to the latest CREL CDO delinquency index (CREL DI) from Fitch Ratings. "The inherently transitional nature of CREL CDO collateral has resulted in an increasing number of these assets becoming delinquent or failing to meet expectations in this stressed economic environment," says senior director Karen Trebach.

Fitch anticipates that delinquencies on loans backed by land for development, turnaround projects and construction properties will continue to increase as interest reserves burn off and sponsors become unable or unwilling to come out of pocket to cover debt service payments. "Mitigating the higher delinquency rates to some extent are higher credit enhancement and more flexibility for loan workouts within the CDO structure," adds Trebach

Lloyds' master trusts unlikely to unwind if nationalised
The £10bn loss incurred by HBOS in 2008 has cast doubt over Lloyds Banking Group's ability to continue as a majority private company. Lloyds is the sponsor of four RMBS programmes, amounting to a third of the non-retained prime RMBS market. Structured finance analysts at Deutsche Bank point out that the sudden non-asset trigger breach in Granite, Northern Rock's master trust, is still fresh in investors' memories.

However, the analysts argue that the UK government would be unlikely to adopt the same downsizing strategy and resultant trust unwind with Lloyds as it initially did with Northern Rock (and which it now appears to have abandoned), given the lender's size and the government's desire to boost lending. "Yet for all master trusts, especially as CPR slows, there may not be enough cash to meet bond repayments, making them dependent on the sponsor. While sponsor support may be forthcoming, it should perhaps not be taken as a given," they say.

ABS CDO completed
S&P has assigned credit ratings to ABS CDO Monte 2008-I. The transaction is a securitisation of European RMBS, ABS, CMBS and CDOs of corporate loans and SMEs. JPMorgan arranged the static balance sheet transaction for Banca Monte Dei Paschi Di Siena (see SCI CDO Database for more).

IG credit spreads improve
Based on credit default swap spreads measured in S&P's CDS Indices, credit spreads for investment grade entities have moderately improved while also showing signs of less volatility than in previous weeks. Meanwhile, spreads for high yield entities have become wider during the week.

Over the last week index spreads for the S&P 100 CDS Index have fluctuated between 121bp and 129bp, closing on 12 February at 122bp. 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 with a return of 0.95%, while the equity index has fallen by over 8.8%.

Index spreads for the S&P CDS US Investment Grade Index have fluctuated between 285bp and 300bp, closing yesterday at 286bp. While all investment grade, 75% of this index is rated triple-B. The S&P CDS US Investment Grade Index Series 1 has had a year to date total return of 1.49%.

Finally, index spreads for the S&P CDS US High Yield Index have fluctuated between 1219bp and 1261bp, ending the week at 1261bp. The index's highest spread this year was 1270bp on 23 January 2009. The High Yield Index has had a year to date total return of -1%, reflective of a year to date increase in index spread of 49bp.

Private equity CFOs denied triple-A eligibility
S&P has revised its assessment of systemic and performance-related risks in its analysis of private equity collateralised fund obligations (CFOs). According to S&P, the changes reflect its belief that going forward the risk/return ratio, amount of cashflow and timing of cashflow investments and distributions for private equity funds may be significantly different from what it has observed historically.

As a result, rated transactions that depend on the performance of private equity funds are no longer eligible for S&P's triple-A rating. The highest rating the agency will assign a private equity CFO is now double-A.

The rating agency continues to base its methodology for rating private equity CFOs on its estimate of the cashflows that the funds are likely to realise, rather than focusing on the reported values of the companies they own. However, its assessment of these transactions now incorporates the belief that - in light of the current unstable market conditions and other factors - the timing and amount of cashflows private equity funds will generate have become less predictable and may not closely follow historical patterns.

Although the private equity fund of funds sector has performed well historically, S&P believes that the sector is vulnerable to the current overall rise in market risk, specifically the following factors: rising corporate defaults; limited corporate financing; increased portfolio asset holding periods; and imprecise valuation and reporting for private equity funds.

CSO criteria update extended to CDPCs
Moody's has confirmed that its revisions and updates to certain key assumptions used to rate and monitor corporate synthetic CDOs will also apply to CDPCs. The agency has begun reassessing all of its outstanding CDPC ratings, including counterparty and debt ratings, and will apply the revised assumptions in the monitoring of their ratings going forward.

Moody's expects to conclude its review of the sector over the next month, including the resolution of the ratings currently on review for possible downgrade. Based on an initial assessment, it expects to affirm the ratings - except for credits currently on review - even after taking into account its revised assumptions and any deterioration in portfolio credit quality. The agency says that this is due to significant capital cushions stemming from the CDPCs' relatively low leverage and/or their limited reference portfolios, which typically consist of thick corporate bespoke tranches with high attachment points.

Since the start of the current market crisis, two CDPCs have been downgraded (SCI passim) as a result of credit losses and portfolio quality deterioration, including exposures to RMBS and CMBS (to which no other CDPCs have exposure). Four have had their ratings withdrawn at their request. At present, Moody's rates five CDPCs with a total of roughly US$1.7bn of rated debt issuance: Athilon Asset Acceptance Corp, Channel Capital, Koch Financial Products, NewLands Financial and Primus Financial Products.

Moody's revised assumptions reflect the expected stress of the global recession and tightened credit conditions on corporate default rates, which are likely to be more variable and extreme than those in other recent historical downturns. Specifically, the changes include: a 30% increase in the assumed likelihood of default for all corporate credits in CDPCs; an increase in the degree to which ratings are adjusted according to other credit indicators, such as rating reviews and outlooks; and an increase in the default correlation the agency applies to corporate portfolios as a result of higher default rates, sector dependencies and overall observed default correlation among corporate credits.

The agency emphasises that qualitative factors are also part of rating committee considerations, including the strength of the counterparty and collateral agreements, the legal environment, documentation features and the potential for selection bias in the portfolio.

SIV ratings withdrawn, full repayments made
Following the repayment in full of the last outstanding senior debt and exchange of junior debt for unrated securities, as of 14 January 2009, Moody's has withdrawn the ratings assigned to the debt programmes of Cullinan Finance Ltd and Cullinan Finance Corp. At the same time, it has withdrawn the ratings assigned to the senior debt programmes and mezzanine capital note programme of Asscher Finance Ltd and Asscher Finance Corp, following the repayment in full of the last outstanding senior debt and exchange of mezzanine debt for unrated securities.

Both SIVs were sponsored by HSBC. Asscher has confirmed that it does not intend to issue any further debt from its senior debt programmes.

Derivatives netting service launched
The Bank of New York Mellon has developed what it says is a new, first-of-its-kind netting service for derivatives dealers. Called Derivatives Collateral Net, the platform utilises a patent-pending technology that enables derivatives dealers to post only their net obligations against all other participants in the system, thereby greatly reducing their gross collateral requirements.

The service, which the company is currently enrolling participants in, automatically aggregates and nets overall collateral obligations, minimising the collateral dealers are required to post and reducing the risks and costs associated with derivative transactions. "Derivatives Collateral Net represents the implementation of the International Swaps and Derivative Association's strategic vision for dramatically reducing the operational challenges associated with the margin process between counterparties. We're making the process more efficient without affecting the fundamental bilateral nature of the credit relationship between the parties," comments Art Certosimo, evp and head of broker-dealer services at the Bank of New York Mellon. "This service spotlights our unique ability to utilise our collateral management expertise and technology to anticipate and serve the emerging needs of our derivatives dealer clients."

The new service represents a collaborative effort between the Bank of New York Mellon's Office of Innovation and its broker-dealer services business. The Office of Innovation provides the framework and resources necessary to accelerate the development of promising new products and services that support client needs.

European SROC figures in
After running its month-end SROC figures, S&P has taken credit watch actions on 362 European synthetic CDO tranches. Specifically, ratings on: 315 tranches were placed on watch negative; 41 tranches were removed from watch negative and affirmed; five tranches were placed on watch positive; and one tranche was removed from watch negative and placed on watch positive.

Of the 315 tranches placed on watch negative: 18 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 297 have experienced corporate downgrades in their portfolios.

Senior ratings remain resilient, says Fitch
Despite the worsening economic environment, Fitch believes that the ratings of senior notes across most European structured finance asset classes and jurisdictions remain resilient and will experience limited negative rating migration. However, according to the agency's latest quarterly update of its European Structured Finance Sector Outlook, extensive negative rating actions will continue to be taken across junior notes in many sectors.

"The deterioration in the global economy and the intensification of the credit crisis since the last quarter are set to maintain negative pressure on collateral performance for many structured finance sectors," says Philip Walsh, md in the EMEA structured finance team at Fitch. "Although interest rates have fallen across the board, access to credit remains restricted and rising unemployment will increase defaults on secured and unsecured consumer debt while increased numbers of corporate defaults will affect other sectors."

However, although Fitch has revised a number of its key economic and monetary variables in the UK and euro area, the majority of the agency's structured finance sector outlooks are unchanged from the previous quarter. This is because the outlooks already factor in this higher degree of stress.

Meanwhile, CDOs of investment grade corporates have seen increased ratings stability following the implementation of criteria changes in 2008, although the outlook for the underlying assets remains negative. Senior tranches of European CLOs have performed relatively well to date, but there have been negative rating actions on some mezzanine and junior notes due to lower recovery rates and the deteriorating credit environment (see separate News Round-up story).

German mezz CLOs under review
S&P has placed on credit watch negative its ratings in six German mezzanine SME CLO transactions. All tranches of the following deals are on watch negative: CB MezzCAP Limited Partnership; FORCE 2005-1 Limited Partnership; FORCE Two Limited Partnership; PULS CDO 2006-1 PLC; PULS CDO 2007-1 Ltd; and PRIME 2006-1 Funding Limited Partnership

The rating actions follow S&P's review of all six portfolios, relying on an updated analysis of concentration risk in each transaction. The current analysis includes a revised view on sizing concentration risks in each portfolio and is based on the 5 January 2009 update to S&P's criteria for rating SME securitisations.

Derivatives back office software enhanced ...
Back office consultancy RiskArt has released Version 5 of its RiskArt Derivatives Management suite. The software provides banks, investment funds, asset management companies, local authorities and other organisations that trade in structured derivatives with operational, administrative, accounting, cashflow and compliance support for structured derivatives (including CDS) - in particular, market traded and OTC derivatives.

The latest release uses Visual Studio 2008 compiler to keep it up-to-date with the latest technologies, state-of-the art techniques and functionalities. As a result, Version 5 offers significantly faster processing of data, along with more extensive parameterisation functions that enable new financial instruments to be incorporated within a matter of weeks without affecting the source code. The firm says that this enhanced solution is highly customisable and stable, without the need for regression tests.

"RiskArt's whole philosophy is very customer centric, with a huge emphasis on personal service on an ongoing basis," explains Franco Marinotti, RiskArt ceo. "The interfacing with customers is done by our senior functional analysts that all have strong, practical backgrounds in financial derivatives and academia, so they understand the cashflow dynamics of each instrument and their impact along the whole of the process." He adds that the firm's in-depth specialisation in derivatives means that its bespoke solutions are cost-effective compared with other offerings, as well as being one of the fastest to adapt to change.

... and new CDS trade management module launched
COR Financial Solutions has launched a CDS module as part of its flagship trade management application, Salerio. Salerio CDS automates and streamlines confirmation processing and provides enhanced exceptions handling for a range of credit derivatives trades through the DTCC's Deriv/SERV platform. This can significantly reduce the post-trade confirmation cycle from ten days to less than 24 hours.

"Although CDS trading volumes are down from last year, automating the processing of complex derivatives remains a key goal for the industry," says Trevor Fromant, global head, banking and STP solutions at COR-FS. "Institutions are seeking ways to improve efficiency and minimise the risk that lies in unconfirmed contracts and post-trade events."

The Salerio CDS module supports a number of post-trade activities, such as assignments, terminations, amendments and increases. Its intuitive exception management helps users identify and quickly resolve trading discrepancies, while its automated capabilities increase operational efficiency.

The module also provides comprehensive post-trade processing capabilities to help improve control throughout the lifecycle of a CDS contract. An example of this is tracking notional amounts for confirmed contracts.

Jumbo synthetic CLO on watch negative
Moody's has placed the ratings of the notes issued by Gracechurch Corporate Loans Series 2007-1 under review for possible downgrade, affecting £3.5bn of rated securities. The rating action on the synthetic CLO has been prompted by the continued deterioration in the macro-economic conditions and expectations of further contraction in GDP output in 2009 in the UK. Additionally, the review is caused by Moody's continued analysis of the borrower financial data on the portfolio.

Moody's is especially assessing data that relates to 2005 and before on a substantial part of the portfolio which may prove very sensitive under the calculation of Moody's one-year EDF. The agency understands that Barclays Bank is preparing the most up-to-date borrower financial data for the portfolio.

Moody's notes that, as of January 2009, the total amount of defaulted reference obligations was £2.2m, relating to four borrowers (0.06% of the total pool balance as of January 2009, compared with 0% as of January 2008). If no principal deficiency ledger exists as of January 2009, the trend of defaulted reference obligations is negative, as most of the defaults occurred in 2008. An increase in the defaulted reference obligation rate is expected, given the high correlation between the GDP growth rate and the company liquidation rate in the UK.

Moreover, the severe downturn in Britain's housing market may lead to worse portfolio credit quality assumptions than initially expected, with 19.89% of the exposure related to borrowers operating in the building and real estate sector. Consequently, the initial average equivalent Moody's rating of the underlying portfolio set at closing as a range of Ba1 and Ba2 will likely be revised.

Basel 2 updates to impact ABCP
Fitch says that new proposals for updating the Basel 2 framework would impact structured finance globally and the ABCP market in particular. The proposals, published last month by the Bank for International Settlements (BIS), seek to update the Basel 2 framework in response to market events of the past 18 months.

"Originally Basel 2 was intended to promote a level playing field by providing neither an incentive nor a disincentive for a bank to securitise assets. However, under the latest proposals for resecuritisation exposures there would be a clear disincentive for banks to provide liquidity facilities to ABCP conduits," says Peter Winning, a director in Fitch's European structured finance team.

The proposals would make several changes to how banks calculate their minimum capital requirements and explicitly list liquidity facilities supporting ABCP conduits as an example. This would mean that such a liquidity facility with an internal or external rating would be subject to a higher risk weighting than a comparable 'regular' securitisation exposure. It is worth noting that this proposal would also impact the risk weighting on certain types of CDOs (see SCI issue 120).

Another proposal regards the use of ratings based on a guarantee a bank has provided (so called 'self-guarantee' exposures). In Fitch's opinion this is likely to reduce the incentive for banks to support their conduits by buying ABCP.

A further proposal would clarify exactly when a liquidity facility is considered a senior or non-senior exposure under the IRB approach. This could impact most liquidity facilities supporting ABCP conduits because the priority of payments typically dictates that the senior fees and expenses are paid before the liquidity facility. A non-senior liquidity facility would be subject to a higher risk-weighting.

The proposals also change the credit conversion factor (CCF) for eligible liquidity facilities under the standardised approach. Similarly, the proposals would also eliminate the 0% CCF applicable to liquidity facilities that can only be drawn upon a general market disruption (under the standardised and IRB approaches). In Fitch's opinion this is likely to have a negligible impact because no ABCP conduits rated by Fitch are supported by market disruption-type liquidity facilities.

Moody's downgrades CSOs
Moody's has downgraded its ratings of 16 notes issued by nine CDOs referencing a portfolio of corporate entities. The rating actions are the result of (i) the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of CSOs; and (ii) the deterioration in the credit quality of the transaction's reference portfolio.

Moody's initially analysed and continues to monitor these transactions using primarily its methodology for CSOs.

CS & AC

CLOs

CLO EOD language: relative value implications

Chris Flanagan, head of global structured finance research at JPMorgan, finds that variations across CLO event of default language are interesting from both EOD likelihood and valuation perspectives

We first tackled the question of CLO event of default (EOD) probability and severity back in September 2008, with follow-up in October 2008. In those analyses we quantified that up to 10% of CLOs have a high probability of breaching O/C-based EOD triggers (in other words, there could be enough cumulative collateral loss such that senior class O/C drops below the common 100% trigger level).

We are constantly refining our approaches in forecasting collateral outcomes and loss curves, but here we take a step back and discuss some of the nuances in EOD language. As we have experienced in the ABS CDO market, the 'devil is in the details', with EOD language driving the likelihood of triggering a default and corresponding impact on the underlying ABS and ABCDS markets.

What is typical EOD language in CLOs?
EOD language varies across CLOs, given that each transaction is a negotiated process. We make comparisons across observed documentation, but as a starting point most typical CLOs have multiple EOD triggers, including failure to pay interest and principal when due on non-PIKable bonds (triple-A and double-A) and usually also a par coverage or O/C EOD trigger. Language for the O/C EOD trigger can vary and there is considerable debate about the likelihood of CLOs breaching triggers, with views differing across documentation types and loss expectations.

How can EOD language vary?
There is no 'one size fits all' guide, but we consider observed variation. These documentation differences include, but are not limited to, the following:

1.) Presence of an O/C-based EOD trigger
Not every CLO has an O/C-based EOD trigger, but we believe the vast majority have this feature. S&P notes O/C-based EOD triggers started to become prevalent in its rated CLOs by at least 2005, so even if we exclude the 2005 vintage in its entirety, the 2006, 2007 and 2008 vintages comprise 63% of today's outstanding CLO market (Chart 2), so it is reasonable to assume most CLOs have an O/C-based EOD trigger. (We note the 2005-2008 vintages total 77% of CLO outstandings).

2.) O/C EOD ratio level
If there is an O/C-based EOD trigger, the trigger level can vary. We believe the most common is 100% O/C coverage of just triple-A, or triple-A plus double-A, depending on the transaction.

However, there can be cases of 102% or an even higher trigger; in some CLOs it may be as high as 105%-110%, but based on our observations, these are very rare. Where the EOD trigger is high versus the more common 100% or 102% level, this may be due to a super-senior wrap by a monoline or financial guarantor, as the institution may have demanded such language to take the exposure.

3.) Classes included in O/C EOD ratio
The most typical EOD O/C ratio calculation involves both the triple-A and double-A rated classes in the denominator, but some transactions only include the triple-A class. Which classes are included (a related point is which have control rights) is an important relative value determinant; we discuss this later in the paper. To properly calculate a transaction's EOD O/C cushion, one needs to breakout each transaction's EOD trigger definition and calculate the ratio on a deal-by-deal basis, including modifiers such as triple-Cs and discount obligations (see below).

Here, we take a simple look at the actual O/C cushions of both triple-A and double-A tranches across the CLO market. Chart 3 and Chart 4 show the current triple-A and double-A O/C cushion distribution in our sample, respectively, where available.

Based on current reported data, we find the current average triple-A O/C cushion is about 11.4%, while the double-A O/C cushion is about 10%. Chart 1 illustrates the historical double-A O/C cushion based on Moody's cash CLO index performance data; note this O/C cushion data from Moody's takes into account triple-C haircuts, which may or may not apply in the actual EOD O/C test (see below).

4.) Whether excess triple-C haircuts are included
Given the surge in triple-C concentrations over the last several months, whether excess triple-C haircuts are included in the EOD trigger is very topical. Since the realised cumulative default rate in CLOs is still a relatively low 2%-3% on average, while triple-C buckets are around 5.5% on average (note: February data read a lower triple-C ratio than 20 January's 7.1%), whether a CLO includes triple-C haircuts in its EOD calculation is one of the most important determinants of EOD likelihood (and relative value).

In fact, in most of the EODs we have observed so far in the ABS CDO market, these were caused by ratings-based haircuts rather than actual collateral losses (only 10%), e.g. missing interest payment. It remains to be seen how EOD outcomes in CLOs ultimately play out, but in ABS CDOs we note the high correlation between the presence of haircuts in the language and EOD occurrence.

Excluding middle market CLOs, S&P estimates that about 200 of its rated US CLOs have EOD ratios with some form of excess triple-C haircut. This universe represents about 38% of S&P-rated CLOs issued since 2004, based on our issuance database.

5.) Whether discount obligation haircuts are included
Similar to the question about triple-C haircuts, there is also the question whether discount obligation haircuts are included in the EOD ratio. Within transactions that do include discount obligations, an important consideration is the price at which the basket is carried (at cost) and whether rating plays a role (if there is a minimum rating).

6.) Who can vote for acceleration and/or liquidation?
It varies as to who is the controlling class (triple-A only, or triple-A and double-A), but in any case it is typically the controlling class who has the right to initiate a vote on acceleration. However, liquidation may require just the controlling class, or potentially some or all of the rated notes. In cases where all of the notes vote, it is typically a supermajority of each class, voting separately by class.

Finally, we also note the controlling class can typically liquidate if the trustee determines that the liquidation would be sufficient to pay off all the rated notes. Such dispersion in documentation makes it difficult to assess EOD likelihood and liquidation impact. On the other hand, varying documentation creates relative value opportunities based on how strong/weak the EOD language is from the perspective of both the senior and mezzanine bonds, and depending on price coverage versus underlying loan prices.

What is the likelihood of CLO EODs?
In our past research we had placed a rough 10% probability of EOD, based on current collateral ratings composition and in the circumstance CLOs experience stress similar to what was experienced in the last cycle. However, the various documentation types will create significant differences in EOD likelihood.

For starters, perhaps the most important driver is whether triple-C haircuts are included. If we assume for argument's sake that 50% of the outstanding CLO market does include triple-C haircuts in the EOD ratio calculation, then in a very simple context up to half of the CLO market is at risk of triggering EOD, should triple-C downgrades become significant (i.e., 30%-40% in some CLOs), even if defaults remain moderate.

Last September we had estimated that the worst 10% of the CLO market are candidates for EODs over the next four years. In other words, the worst 10% of today's CLO universe based on current ratings have the greatest probability of senior class O/C falling close to 100% coverage. In this simulation we assumed the EOD trigger did include triple-C haircuts; the CLOs that were the most likely EOD candidates tended to have a larger-than-average single-B minus asset concentration.

Conclusion: not all bonds are created equal; there is relative value
While we do not have observed secondary prices, perhaps the most obvious conclusion is that these language differences should create material price tiering based on views of EOD likelihood and impact to the various tranches. There are clearly opportunities (and risks) created by the varying documentation types, structures and EOD probabilities based on trigger treatment in CLO language.

All else being equal, the presence of triple-C haircuts and other features makes EOD likelihood greater in those transactions. For triple-As, whether the transaction has a triple-C haircut should drive relative value, as the EOD trigger with the triple-C haircut implies principal would be returned early subject to the control rights.

For double-As, the concept is similar, but the additional nuance of who is the controlling class becomes important. The makeup of the controlling class is important to double-A holders because, while they cannot block the triple-A holder from accelerating the transaction and potentially shutting off interest cashflows to the double-As, they would be able to block liquidation in the event sale proceeds were not enough to make them whole.

For mezzanine classes such as single-A, whether or not the EOD trigger has triple-C haircuts is also important as it drives EOD likelihood. But so is whether the transaction requires each class of investors to vote on liquidation, as in that case the single-A is protected from a liquidation scenario (which at current loan prices implies partial or full principal loss). In addition to these EOD language differences, the price entry point and prices of the underlying (together, the price coverage) are important in assessing the likelihood of getting back principal, should a liquidation scenario be in the cards.

© 2009 JPMorgan. All rights reserved. This Research Note is an extract from 'JPM CDO Fixed Income Markets Weekly', first published by JPMorgan on 6 February.

Trading

Trading ideas: cow bell sounds

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on CBS Corp

The outlook for the media sector looks dimmer and dimmer by the day. With advertising companies around the globe reporting revenues dropping by 20%-45% and a recovery not likely until at least 2010, we highly recommend buying protection on CBS Corp.

The company's massive exposure to advertising revenues puts it in a precarious position. This, combined with substantial debt and a rapidly declining market capitalization, will likely provide substantial upward pressure on its credit spread and we recommend buying protection ahead of its earnings announcement this week.

With a bleak outlook ahead, CBS' debt profile is going to cause serious strain. The company maintains US$7.1bn in total debt, with more than US$1.5bn maturing in 2010, while its cash balance has been steadily declining (Exhibit 1).

Exhibit 1

Though it does have an available credit facility, due in 2010, it does little to help with the prospect of retiring future debt. The equity market has punished CBS severely for its prospects, taking its total market capitalisation down to less than US$4bn. Exhibit 2 shows a time series of its total debt to market cap and clearly CBS is headed for trouble.

Exhibit 2

We see a 'fair spread' of 850bp for CBS based upon our quantitative credit model, due to its weak equity-implied default probability and change in leverage. The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit).

After returning to fair value in December, CBS' credit spread has traded in a range, while its expected spread shot upwards, leaving the differential at 400bp. Exhibit 3 shows a time series of CBS' spread and expected spread.

Exhibit 3

Buy US$10m notional CBS Corp 5 Year CDS protection at 450bp.

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).