Contents

CDS

Unsustainable trend

Time for corporate CDS to price in sovereign risk?

Sovereign CDS levels continue their widening trend, while corporate CDS are seemingly moving in the opposite direction. Just this week German sovereign CDS reached historic highs and US sovereign CDS breached 100bp for the first time. Observers suggest that this development is unsustainable and expect corporate CDS to widen when the market starts properly pricing in sovereign risk.

"The tightening of corporate credit risk against a background of widening sovereign CDS is hard to justify in the current climate," says Søren Rump, ceo of Global Evolution. "The only way to explain it is by assuming that the market believes government stimulus packages will eventually work and have a positive knock-on effect onto the corporate sector."

Rump also suggests that asset managers and banks have managed to convince the majority of institutional investors that investment grade corporates, high yield and leveraged loans are very cheap right now. "Many of the investors I speak to are of the opinion that corporates are the right place to invest at the moment, but I disagree," he adds.

According to Puneet Sharma, credit analyst at Barclays Capital, European sovereign credit risk is one of the most underpriced risks in European credit. Indeed, while sovereign CDS are trading between 100bp-250bp versus 10bp-50bp pre-October 2008, the iTraxx Main index is currently trading at around 175bp.

"This appears to suggest that corporate CDS has not priced in any additional risk of corporate credit worthiness decline since Lehman filed for bankruptcy in September," he says. "We believe that, even if sovereign CDS is pricing in multi-notch downgrades of European sovereigns as opposed to defaults, then the impact on corporates could range as high as another 60bp, in our estimation."

Whereas a sovereign has a variety of tools at its disposal to prevent default - taxation, printing money or even seizure of assets - corporates lack such flexibility. Consequently, sovereign creditworthiness in the vast majority of cases provides a floor to corporate creditworthiness.

"As sovereign risk rises, this floor gets elevated, which would spill over to corporates. Exceptions to this are large, global corporates which are generally very highly rated," continues Sharma. He adds that, in the case of financials, credit risk has become sovereign risk recently.

The correct pricing of sovereign versus corporate risk has been a topic of discussion in emerging markets for many years. "It is interesting to see it now go over to the more developed world," comments Rump. "We have always tended to stay away from EM corporates, as in negative markets they severely underperform. Even if the corporate is fairly strong to start with, when the sovereign is in trouble the mechanisms it uses to combat the negative environment - such as higher taxes, capital controls etc - really hurts the corporates."

He continues: "Directions in both corporate and sovereign CDS spreads are clearly extremely uncertain. But I would short corporate credit versus sovereign credit in both developed and emerging markets."

Sharma points to cyclical, low-rated names that are trading tighter than the sovereign, yielding attractive cheap shorting opportunities. In financials, there are some banks that have not yet fully priced in government support - here Sharma recommends longs versus the sovereign.

AC

Correlation

Dispersion rules

Investors favour single name CDS over top-down index positions

Risk in CDX IG index tranches currently appears to be being driven by dispersion - or the differential between various sectors and names. While at first glance the index seems to be relatively stable, significant movement is in fact occurring underneath the surface as investors focus on single name CDS rather than top-down index positions.

Current index prices are not reflecting fundamental macro risk appropriately: while in 2007 credit led the widening over equities, recently the index has remained stable, despite the underperformance in equities. Alberto Gallo, US credit strategist at Goldman Sachs, suggests that two technical factors are behind the index remaining tight.

"First, trading volumes are down compared to last year, probably because investors are waiting for a CDS central counterparty to be established," he explains. "Second, over the past month correlation desks have been less active in their hedging (both hedging less frequently and hedging less of their books), focusing on hedging single names that they believe will default rather than hedging all mark-to-market risk."

One CSO manager warns, however, that if a position is long risk, buying single name protection on distressed names won't help because the defaults are priced in to distressed CDS levels. He indicates that most hedging activity continues to be in systemic risk containment rather than single name idiosyncratic risk management.

Nevertheless, around 60%-70% of IG CDS index constituents are rated triple-B and, if - as Goldman predicts - 15%-20% of them are downgraded (depending on whether a baseline recession or a deep recession hits), this is likely to result in 18 or 19 fallen angels and a significant price drop of around 15-20 points on each. Any potential carry will barely compensate investors for this price drop; hence spreads are too tight.

"The CDX IG index is seeing spread dispersion within the index and also a higher number of downgrades, which increases the likelihood of senior mezz tranches becoming impaired," continues Gallo. In order to play the differential theme, Goldman Sachs credit strategy suggests that investors go long IG AA/A/BBB cash and short potential fallen angels.

In addition, index tranches are seeing pressure because equity and mezz are saturated, while super-seniors are tightening as systemic risk dissipates. Indeed, CDX HY mezz tranches (15%-25% and 25%-35%) have widened by around 10 points since the beginning of the year, as credit deterioration is increasingly priced in. CDX IG senior tranches (7%-10% and 10%-15%) have also widened substantially versus the index.

"Consequently, the widening in the 7%-10% and 10%-15% tranches is likely to continue over the coming months, with the catalyst being widening spreads and continuing downgrades," Gallo explains. "But, while speculative investors have largely already unwound their equity and mezz holdings, it is a slower process for hold-to-maturity accounts. Unwinds are likely to appear in waves, as investors come to realise that certain instruments aren't performing as anticipated against the backdrop of lower recoveries and increasing defaults."

Indeed, the CSO manager expects the squeeze in mezz tranches to continue, as they behave increasingly more like equity and potentially become equity after the next few defaults hit.

In terms of the high yield and LCDX indices, meanwhile, seniority in the capital structure should compensate for compression in recovery rates (around low-20bp and 35bp-40bp respectively). However, it's difficult to compare the two indices because LCDX doesn't have a super-senior tranche, which reduces the convexity of the position. Investors nonetheless hope to see a division of the 15%-100% tranche to create a super-senior portion that will enable them to short the index and take advantage of higher loss expectations, potentially by the next index roll.

CS

Monolines

Setting the template

Monoline credit events avoided through innovative reinsurance agreement

MBIA's restructuring (see last week's issue) sparked concern about potential credit events being triggered. However, this has been avoided through the innovative use of reinsurance, with other monolines now said to be looking at similar solutions.

Questions were raised about whether a restructuring credit event or a succession event would be triggered under MBIA's restructuring. But, according to one credit derivatives lawyer, the clear view from the market is that neither event has been triggered.

"By using the flexibility of the insurance agreement, MBIA has split the risk in such a way that the primary CDS obligation remains," she explains. "It is a more subtle redistribution of risk that doesn't trigger a credit event or a succession event, based on the publicly information that is currently available."

The restructuring essentially involved MBIA's US municipal finance book being reinsured by a newly-formed company (National Public Finance Guarantee Corporation) and the reinsurance agreement with FGIC being ceded to the new company (a total net par outstanding of approximately US$537bn). All structured finance and international exposures will remain with the original insurance vehicle (MBIA Insurance Corp). In addition to the reinsurance protection, which is on a cut-through basis, National will issue second-to-pay policies for the benefit of the policyholders covered by the assignment - meaning they have a direct claim on the new entity and presumably benefit from that entity's higher ratings.

"From a practical perspective, MBIA itself hasn't issued any debt and the restructuring amount for a credit event for the purpose of the CDS (the interest/coupon) hasn't been reduced or extended, for example," the lawyer confirms. "In terms of a succession event, the issue hangs on whether existing debt has moved to a new company and, as a result, whether the existing swaps on MBIA need to be split."

As the municipal portfolio has been reinsured, MBIA remains liable and therefore there will be no split for the purposes of the CDS. And, although the reinsurance agreement was moved to the new entity, this doesn't count as a relevant obligation for the CDS. Under the monoline credit derivatives supplement, a 'qualifying policy' requires an irrevocable agreement, but this has been avoided because of the various conditions to payment.

While MBIA denies that it is a 'good bank/bad bank' split, the restructuring does have many of the characteristics of such a partition, according to RBS credit analyst Michael Cox. He says it is difficult to separate the ratings cuts resulting from the restructuring (see News Round-up) from action that may have been taken anyway. "However, the basic problem is that MBIA Corp will retain the problem credits (although it will lose the US public finance risk) and will have nearly US$5bn less capital to support them."

"Although regulatory approval has been received, I doubt many people will see it as anything other than a severe negative for those with exposure to MBIA Corp," Cox adds. "It still intends to be active in structured finance and international markets in due course, but the damage inflicted to the franchise as a result of the restructuring could be terminal for the business in Europe: the fact that MBIA has taken action that has resulted in a cut deep into junk will not rest easy with investors."

Whether such a radical solution will set a template for other monolines to copy is yet to be seen. The new structure isn't particularly complicated, but for any new company to be viable it has to attain good enough ratings. S&P has said that an upgrade of National, based on successfully raising capital and credibly ring-fencing its operations from MBIA, would most likely remain within the double-A category.

Ambac is certainly rumoured to be looking at similar proposals in an attempt to salvage some new business capacity. According to one CDS trader, recent widening in Ambac spreads implies a "50/50 chance" of that happening.

CS

ABS

Agricultural ABS launched

South African-based Gro Capital, a wholly owned subsidiary of AFGRI Operations Ltd, has completed a R².5bn securitisation of part of its debtors' book. The programme is structured and arranged by Rabobank and is part financed by Erasmus Capital Corporation, an international funding conduit with assets worth around R40bn.

Erasmus is funding the R1.25bn equity slice, and the balance will be provided by both the local and international capital markets. Rabobank is underwriting Erasmus` funding with a liquidity facility for R1.25bn.

Chris Venter, ceo of AFGRI, says that the transaction will allow the firm more flexibility in raising agricultural finance for its customers, the farmers. "Historically, the South African agricultural sector was limited in terms of the providers of agricultural finance," he notes. "This transaction is truly a breakthrough for the agricultural sector, as we have proved that the South African agricultural sector is of such a high standing that a reputable international bank is willing to fund AFGRI and the South African farmer in a time of turmoil for the international banking sector."

AC

CLOs

Microfinance CLO completed

SKS Microfinance, India's largest microfinance organisation, and ICICI Bank have completed a Rs2bn microfinance securitisation. The transaction will result in income-generating loans averaging Rs9,500 being distributed to over 200,000 unbanked families - belonging to groups identified as 'weaker sections' of society.

According to the two firms, the partnership combines SKS' customer acquisition and management model with ICICI's experience in financial structuring for microfinance institutions, networks and investors in emerging markets to fulfill a shared objective of greater financial inclusion and poverty alleviation through commercially viable and sustainable lending programmes.

Dilli Raj, cfo of SKS Microfinance, says: "For the first time in the MFI history, a pool comprising receivables exclusively from the weaker sections of the society is securitised and placed with ICICI Bank. We will continue to manage these receivables for ICICI Bank through the terms of these receivables. This structure achieves an amalgam of the funding capability of a banking giant like ICICI and the credit delivery skills of SKS."

AC

Operations

CDS clearing commitments made

Nine CDS dealers have signed a letter to Internal Market and Services Commissioner Charlie McCreevy confirming their engagement to use EU-based central clearing for eligible EU CDS contracts by end-July 2009. At the same time, regulatory bodies with direct authority over existing/proposed CDS central counterparties (CCPs) are discussing possible information-sharing arrangements and other methods of cooperation.

The letter to McCreevy commits the signatories to work closely with infrastructure providers, regulators and the European Commission in resolving outstanding technical, regulatory, legal and practical issues. Each firm will make an individual choice on which central clearing house or houses might best meet its risk management objectives, subject to regulatory approval of any such clearing house in Europe.

The co-signatories of the letter are: Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS. They say that their efforts mirror the engagement the industry has made in other jurisdictions in the interests of a globally cohesive regulatory framework for clearing.

"This commitment provides the basis for constructive dialogue with the European Commission, both on arrangements for central clearing and on related regulatory matters," says Eraj Shirvani, ISDA chairman and head of fixed income for EMEA at Credit Suisse. "ISDA and its member firms will continue to work closely with the European Commission, national and international regulators and infrastructure providers to ensure a sound and efficient regulatory framework for central clearing of the CDS market."

McCreevy has welcomed the commitments, both to agree to central clearing in Europe and to engage immediately in a dialogue to resolve all outstanding technical issues. "Central clearing of CDS is particularly urgent to restore market confidence," he says. "Given the size of derivatives markets, I am looking at whether other measures might be necessary to make sure they are adequately supervised and do not pose unnecessary risks to financial markets."

The Commissioner had indicated that the only other option would have been a legislative one, which possibly would have taken effect much later.

Meanwhile, in order to 'keep' business in the eurozone, the French central bank has reportedly called for the creation of a consortium of eurozone banks and a merger of the different clearing houses in region. However, many observers claim that two clearers would be cost intensive.

According to credit strategists at UniCredit, some market participants have suggested that if the French authorities are playing the economic nationalism card, there is little hope for Europe to build a widely used clearing solution to match the one being established in the US. Consequently, Europe could be left with a much less liquid credit trading market than North America, thereby hampering its economic recovery.

Nevertheless, representatives from regulatory agencies with direct authority over one or more of the existing or proposed CDS CCPs are in discussions about possible information sharing arrangements and other methods of cooperation within the regulatory community. The move follows an initial meeting held at the Federal Reserve Bank of New York on 12 January 2009.

The primary objectives of the discussions include: mutually supporting each regulator in carrying out its respective authorities and responsibilities with respect to CDS CCPs; and applying consistent standards and promoting consistent public policy objectives and oversight approaches for all CDS CCPs. To facilitate communication among the regulatory community with respect to all CDS CCPs, CDS CCP regulators plan to host a workshop in the near future with representatives of other interested regulators and governmental authorities that are currently considering CDS market matters, to discuss the CDS CCP regulatory interests and information needs of other authorities and the market more broadly.

The discussions included representatives from the US Federal Reserve, Commodity Futures Trading Commission, UK Financial Services Authority, the German Federal Financial Services Authority (BaFin), Deutsche Bundesbank, the New York State Banking Department, the Securities and Exchange Commission, the European Central Bank and the Hungarian Financial Services Authority.

CS

Operations

Recursive boundaries in finance

Stefan Wasilewski, ceo of Contingent Capital Corporation, discusses the need to model sustainability in order to convince shareholders of risk

Reprise
Back to Alan Greenspan (see SCI issue 118): in my opinion, he wasn't at fault, just deceived. Not by anyone in particular, but by his own paradigm of thinking. Though I believe his accumulated wisdom with regard to the global economy and the US banking system is great, his own paradigm of control relates to a generation ago.

It appears that we have a person who has led with honour, but the system either outgrew him or changed without anyone's approval. Greenspan's 'steel' assumptions (see his early career) were wrong because technology had replaced it without reporting correctly to him.

Control is all about setting, monitoring and responding to the correct parameters in order to effect a change in the system in view. The problem is, if you don't properly define the system and hence the parameters, how can you 'control' something? Also control means having the ability to affect the changes required.

The latter is very important because 'action' will be needed in a consistent and concerted manner if the effects are to be realised, thereby resetting the 'system' within the parameters you've set. In the end the economy is all about social networks and simple rules of a game, but not the network or game that has commonly been portrayed.

Any network based on the actions or results of 'rules' is based upon the 'GIGO principle - garbage in equal's garbage out'. The capital and credit markets essentially operate on a 'grund norm' of rules, commonly accepted processes and parameters that are iteratively built upon to create bespoke products. The problem is that if the basic rules rely upon interpretations from bad data, then all subsequent parameters are wrongly set and the processes output garbage.

For those of you too impatient to understand
What we're about to say is that, by changing the basis upon which we form enterprises and correctly mapping their functionality to a standard, we can bring more information into pricing credit by understanding a business' context and control methodology. It's not difficult. An initial paradigm shift analysis is easily scalable and explains why the misuse of data and analytical processes has resulted in repeated failures in the financial markets.

We will show that an 80-year-old science has:

• the mathematics and rigour to predict system failure, but finds a balance between autocracy and anarchy (democracy)
• the ability to control, but also to invest freely
• is a 'laissez faire' approach, but bounded by different control parameters at each 'system' level - i.e. each system is free to run itself, but clear parameters (boundaries) will be set before outside interference occurs to bring errors under control. It's like the UK's 'principal-based regulation' approach, but with continuous monitoring by regulators.
• can use all the same processes within credit analysis, but modify them to give a richer picture.

What about credit?
Let's consider a simple aspect of credit. Time: it's essential to the existence of the business, the context it's within and how management controls the enterprise. Wow, where do you get all that information?

Answer: with difficulty, because most businesses do not collect all of it. They are input, output, resources-based, with a bias to net profit and not how the company is operating.

So, how do you go about creating an easily understandable data set that fulfils these requirements? Miyamoto Musashi¹ had a good solution: if you're finding it difficult, change your spirit and the solution will become apparent. This means change your paradigm, stop looking at ancient reports and accounts, and start looking at what they're doing in the context of their business milieu.

By establishing a systematic approach to analysing a business and its context, data can be created that modifies existing credit indicators and therefore enhance the predictive ability of individual businesses and markets as a whole.

How does this apply to banking and capital markets?
Now let's move onto banks and the capital markets. If the credit markets are ill advised, think of what the banks' situation would be: fed incorrect data, investing other people's capital and ruled by emotion, the concept of 'a sustainable economy' is an oxymoron.

So, let's dissolve the problem, not solve it, by moving the paradigm of investment and control; instead of 'robbing Peter to gamble with Paul', maybe we should define what a system is and how each client fits within it. That's novel: it'll supply data for the business and its marketplace, along with the rate of change.

The market has already begun the paradigm change: instead of being 'earnings' based, it has started to look at what capital is required. In itself a good move, but without putting capital in its right place in a broad scheme of operations the same processes that brought the current problem will reassert themselves and hey presto, we're back to the same problem.

What we need is a proper definition of a business in functional terms, regardless of its internal processes - a kind of 'General Relativity Theory' for business. We need to be able to define a 'system' and how it interacts with its environment, so that we know how its management controls the business.

So, what are 'recursive boundaries'?
Is this a new thing, a difficult subject? No, the genesis of 'system theory' is over 80 years old, supplied by biologists, social anthropologists and the original computer nerds.

People like W Ross Ashby, W McCulloch, H von Foerster, Stafford Beer, G Pask and N Weiner started the ball rolling, but others like Frederick Vester, John Holland, Stuart Kauffmann and lately Duncan Watts have contributed complexity theory into the mix to bring the whole thing to a state where it moves from atom to universe in a series of nested organisations with clear boundaries and interactions. Add Eric D. Beinhocker and his 'The Origin of Wealth' and you have a direct application to economics.

Oh dear, a little complex? Not really; what they are saying is that 'nature' seems to operate by creating a set of nested organisms, each with defined boundaries that operate on simple rules. Each can combine with complementary others to create bigger organisms, like Russian Dolls; imagine looking at your body and then internally to your component parts, each an organism but together something greater.

So to the global economy: a set of inter-dependent organisms, with its own boundaries but dependent upon each other to survive. How well it does, depends upon the level of communication and internal control.

So, what are 'recursive boundaries'? The diagrams show what we mean in two ways, one visual (The 'Droste Effect': see Wikipedia) and the other economic (Exhibit 1).

Exhibit 1

Each enterprise becomes well formed when it sets boundaries to its internal processes; defines inputs, outputs and operational rules; and those parameters that confine it. When an enterprise is so defined, it is said to be a level of recursion from which you can say it operates within the next level up and has some that operate within it.

Look up 'recursion' in Wikipedia and you'll find plenty of references: it's the mathematical approach we want, along with a discussion on reverberating networks. The formal mathematics is also there and a clue to how 'set theory' plays a part in analysing networks. It really only works when you've identified self-similar functional wholes because - as the system closes and becomes internally self-regulating - you are left with inputs and outputs; the rest is a black box for which its function and parameters become discernable from the analysis of past activity.

Well-formed boundaries are good
By simplifying the information and determining the links within the system and its environment, a 'Sensitivity Model' [The Art of Connected Thinking: Frederic Vester] can be created for the processes and the functional parts compared to a general map [The Viable System Model: Stafford Beer].

If the boundaries are not formally set, then we have open networks that can range from chaotic to complex. Neither is bad; it just depends upon yours and the market's level of risk taking capacity because it will certainly be volatile. But that's a market for you - one person's meat etc.

If the market is not deep enough or confidence is removed in the fundamentals, then a catastrophic drop in trading occurs as value becomes impossible to set. It doesn't mean that the economy's bad, just that the reason why it over-heated must be removed or dampened, so that the underlying cashflows of good business restore confidence.

This will happen in a 'complex' market because they have inherent rules that trigger a stabilisation process around a particular point or 'attractor'. You may not like it because another shock needs to occur before normal business is resumed and the attractor removed. A stochastic process is one whose behaviour is non-deterministic in that a system's subsequent state is determined both by the process's predictable actions and by a random element.

'Chaotic' systems in economies are generally bad for you, so you don't want that unless it is localised. They are deterministic systems highly sensitive to initial conditions.

So, well-formed boundaries are good for you? Yes, because, while nothing is a given (remember: correlations are dynamic, conditional and unknowable - see SCI issue 118), the inherent stabilisation processes within a well-managed enterprises anticipates oscillations and compensates by smoothing results over time.

Rating agencies, system theory and 'The Crunch'
You cannot productise the economy and that's what I believe the process of rating a business does. Notwithstanding the fact that the assumptions are opaque, the focus inappropriate and the data invariably wrong, the whole concept of an unregulated, for-profit entity managing a crucial part of the global economy is wrong.

Having dealt with most of them, I think individuals tried to do a good job but the approach was wrong. How can you assess the viability and sustainability of a business without a formal structure of both the business and its market? To add to this, they only use out-of-date data in accounting formats that are themselves regulatory nightmares.

In the early 1990s I ceased creating structured finance products because the reliance on accounting or regulatory arbitrage was leading to the 'robbing Peter to gamble on Paul' routine. Insurance companies and banks were leveraging client's money to gamble on a system they did not understand.

Anyone going to a casino knows the house always wins; they just kid themselves that they're better, when they're only lucky [Fooled by Randomness: Nicholas Taleb]. Another reason was that these products have little or no embedded liquidity; rather, relying on derivative trades with complex, opaque rules: a lawyer's heaven.

The rating agencies are a service, not a business, and should therefore be regulated by government. However, first they should restructure how they form opinions of a business and its viability, for a triple-A rating is a measure of longevity, as well as risk price. But, as we've seen, governments can fail and we have a global economy, so individual enterprises must be measured in time, space and connectivity for risk.

Where's the driver of the car?
A system is like a car; its functional parts may be well honed and coordinated, but what use is it without the driver that must gauge the road, and what use is the road without the reason to travel along it?

System theory is not just theory; it's been applied to businesses, banks and indeed countries. Frederic Vester's book gives some good examples and Stafford Beer's 'Diagnosing the System' can show you how to compare your business to a general map.

Both are good maps to guide you, but you are the driver! This is what you, the manager, will be measured on - not whether you can confound investors by P&L massage: cashflow is still king.

Systems models and Gödel's incompleteness theorem
I have a paper to write that compares the application of processes and models in the insurance and capital markets. It will fundamentally say that, without a formal understanding of what a system is, how can processes within it be properly regulated?

All processes are rules and Gödel basically said any such system you set up can be circumnavigated: so don't set up complex regulations, but monitor formal functional systems for flows and events that can lead to 'tipping points'.

For example, the financial industry effectively became the gate-keeper to capital for business, but - without a formal understanding of viability - the natural process of birth, develop, die for businesses was interrupted because the 'birth' bit was still-born and now 'venture capital' is an oxymoron.

Human nature took over and VC funds became structured financiers and then hedge funds, leveraging equity risk against rated debt with return expectations so high that they left the real economy behind. Everyone wants returns at 40% ROE, but if the economy has a real return below 10%, where's the other return coming from? Equity risks were being taken at debt prices.

Regulators cannot regulate if they're not in the market. The data flow and discrete decisions that control a market network are 'complex', need a formal structure to model and are partly path-dependent. I hope some sense will come to the UK and the Bank of England is given control over some of the essential capital markets, while the FSA regulates the rest. As I mentioned before, a regulator must be part of the system in order to control it.

Business managers are at the front line, but not for themselves, for all stakeholders. It's easy to convince oneself as a manager that 'shareholders want returns', but a director also has an obligation to disclose the risk levels at which they are allocating their capital. Again, if you cannot model sustainability, how can you properly convince shareholders of the risk/return?

Hope
It is not without hope that we face the current market forces of 'the crunch', but if we are to avoid the continual repetition of boom-bust, we need better models to measure capital risk, and the tools are there. Am I going to tell you how to do it? No, because there's a lot of money to be made in bringing the first really Operational Risk Metric to market. But if you want help, please call.

Footnotes

¹A Book of Five Rings (Go Ring No Sho). A book on strategy written by the samurai warrior Miyamoto Musashi circa 1645.

Global credit head departs

The latest company and people moves

RBS' global head of credit markets, Symon Drake-Brockman, has left the bank. According to a spokesperson for the bank, Drake-Brockman decided to leave RBS to focus on other opportunities.

"Symon played a key role in the growth and strategic development of GBM and we wish him well for the future," the spokesperson says. Drake-Brockman took on the role of global head of credit markets a year ago, following RBS' integration with ABN AMRO. Previously, he held the role of head of debt markets.

CDS chief leaves bank
Keith Grimaldi, global head of credit derivatives at UBS, has left the bank. A spokesperson for UBS declined to comment.

Distressed CRE investment group launched
JEMB Realty, a real estate owner, developer and management company, has launched Basis Investment Group in order to capitalise on the unprecedented opportunities in the debt market. Tammy Heyman, who previously directed CWCapital's fixed and floating rate capital markets lending division, will be president of the new venture.

Basis Investment Group is a debt investment platform that acquires and originates high-yield performing and distressed whole loans, mezzanine loans, B-notes, gap equity and select CMBS investments on behalf of its clients. In addition to debt investment, Basis will provide origination, lending and underwriting support to third parties on a separate account basis.

Heyman and the Basis Investment Group management team have originated and securitised in excess of US$30bn of fixed, floating rate and mezzanine debt products over the last decade, while JEMB Realty operates more than 7.2 million square-feet of real estate in North America and has deep entrepreneurial roots extending over 30 years.

Merger expected to provide value creation
A merger agreement has been announced between real estate investment trust Alesco Financial (AFN) and its external management company Cohen & Company. The agreement will see Cohen & Company surviving the merger as a subsidiary of AFN (although Cohen & Company will be treated as the acquirer for accounting purposes), with its members having the option to exchange each of their membership units in Cohen & Company for either shares of common stock of AFN or replacement units of membership interest in Cohen & Company that may be exchanged into shares of AFN in the future. Holders of common stock of AFN will still hold their shares of AFN.

AFN will continue to be a publicly traded entity and is expected to operate as a C-Corp for tax purposes. Pursuant to the merger agreement, AFN will complete a one for 10 reverse split of its common stock.

It is currently expected that former shareholders of AFN will own 62.4% of the shares of AFN's common stock immediately after the merger and former unit holders of Cohen & Company will hold the balance. If all Cohen & Company membership interests were to be converted into AFN shares, current AFN shareholders would own 38.5% and former Cohen & Company members would own 61.5% of the combined company.

The terms of the merger also include a 'go-shop' provision for AFN to pursue superior merger or other strategic opportunities for a period of 40 days from the date of the execution of the merger agreement. A special committee of AFN's board has instructed its investment banker, Stifel, Nicolaus & Company, to assist it in evaluating any potentially superior opportunities.

Upon the closing of the transaction, Daniel Cohen, chairman of Cohen & Company, will retain the role of chairman and assume the role of ceo of AFN. Christopher Ricciardi, ceo of Cohen & Company, will serve as president of AFN and ceo of the combined company's capital markets business. Joseph Pooler, Cohen & Company cfo, will become the cfo of AFN.

In the near term, the merger of the two companies is expected to provide the combined entity with enhanced financial resilience, synergies and economies of scale to better manage through current market conditions. The transaction is expected to be accretive to AFN shareholders. AFN's business model will shift from a capital investment company to an operating company with various types of revenue streams and positive cashflow from operations.

The two firms anticipate that over the medium to long term the combination will create a platform specialising in credit-related fixed income trading and management and a combined company with greater capital resources to pursue opportunistic initiatives in a distressed market, which may include potential acquisitions of other asset management and investment firms.

"This agreement is a critical milestone towards a transaction that we believe will preserve value for AFN shareholders in the near term, while providing significant potential value enhancement opportunities over the medium to long term," Cohen explains. "The fixed income and structured credit markets continue to be faced with significant challenges and dislocation. For companies with deep industry expertise and financial resources, this dislocation creates multiple opportunities for: value creation through strategic investments and acquisitions at attractive valuations; providing credit fixed income trading services to institutional investors that are currently underserved in this space; recruiting and retaining the best and brightest in the industry; and originations and underwriting of debt issuances as required by clients."

The merged company expects to generate diversified revenue and fee income streams through the following three operating segments: capital markets (consisting of sales and trading, as well as origination, structuring and placement of fixed income securities through Cohen & Company's broker-dealer subsidiary Cohen & Company Securities); asset management (via a variety of investment vehicles, including investment funds, permanent capital vehicles and CDOs, as well as seeking to generate fee income through strategic 'roll up' acquisitions of credit fixed income contracts at attractive valuations); and principal investing (comprising primarily of AFN's investment portfolio and Cohen & Company's seed capital in certain investment vehicles and the related gains and losses that they generate).

The transaction is expected to close during the second half of 2009.

REIT sees reorganisation
Following the merger agreement between Cohen & Company and Alesco (see above Job Swaps story), Daniel Cohen has resigned as the ceo of RAIT Financial Trust in order to accept the position of ceo at Alesco Financial. He will continue to serve on the board of trustees of RAIT.

RAIT has promoted Scott Schaeffer to replace Cohen as ceo, while also continuing to serve as RAIT's president. Prior to this promotion, he had served as RAIT's president and coo.

In addition, the REIT has promoted Raphael Licht to serve as its coo, while also continuing to serve as RAIT's secretary. Prior to this promotion, Licht had served as RAIT's chief legal officer, chief administrative officer and secretary since December 2006.

US structured finance practice opens
Ashurst has taken on ten partners from McKee Nelson in New York and Washington for its new US structured finance practice. The new partners have extensive experience of advising on a wide variety of structured products, including credit and equity derivatives, distressed debt, municipal bonds, funds, CLOs/CDOs, general US securities advice, tax issues and ERISA.

The team joining Ashurst comprises William Gray, Douglas Bird, Richard Davis, Scott Faga, Eugene Ferrer, Tom Glushko, Steven Kopp, David Nirenberg, Patrick Quill, Michael Voldstad and Alice Yurke.

Portfolio strategist hired
Broadpoint Capital has hired Doug Colandrea as an md in the debt capital markets division, with responsibility for research in the telecom, cable, media and entertainment sectors. Colandrea was most recently employed at JPMorgan, where he was an md in the portfolio strategies group with the FAST (Financial Analytics and Structured Transaction) department.

SecondMarket hires for new initiative
Illiquid asset trading venue SecondMarket has hired Jeffrey Bollerman to help lead its newly launched LP interest market (see also News Round-up). Prior to joining SecondMarket, Bollerman developed investment products for Citigroup Global Wealth Management and was an attorney at Ropes & Gray, representing hedge funds, private equity funds and other private investment vehicles.

"These are unprecedented times in the financial markets and we look forward to helping limited partners and fund managers address their immediate liquidity needs," says SecondMarket ceo Barry Silbert. "We also look forward to helping develop a sustainable long-term model for private equity, venture capital, hedge fund and fund of funds businesses."

REIT conducts CDO buyback
In its Q4 and full-year 2008 results, NorthStar Realty Finance announced that it has acquired US$31m face amount of its own CDO notes at an average 74% discount to par, with ratings ranging from double-A to triple-B minus, and recognised a US$15m gain compared to the carrying value of the notes.

David Hamamoto, the REIT's chairman and ceo, noted: "Our belief continues to be that aggressively managing credit, liquidity and continuing to seek alternative sources of capital should enable our commercial real estate investment platform to be opportunistic in accessing the exceptional opportunities that are likely to arise in [current market conditions] and to thrive when market conditions improve."

Carador ...
As at the close of business on 31 December 2008, the unaudited net asset values per share for the Carador permacap were €0.49 for the euro shares and US$0.62 for the US dollar shares. The euro share class NAV decreased by 5.1% compared to the November NAV prior to the amalgamation with Abingdon Investment Limited (this is the first estimated USD share class NAV following the amalgamation).

The decrease in the company's NAV was mainly due to the change in the revenue recognition policy from accrued income to received cashflows, foreign exchange effects, the additional accrual for year-end expenses as a result of the change in accounting reference date from 31 March 2009 to 31 December 2008 and the costs incurred as a result of the amalgamation.

Excluding the costs of the merger, this month's calculations include an estimated €166,668 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0012 or US$0.0017 per share.

... and Volta Finance report
Permacap Volta Finance has published its January monthly report. As of the end of January 2009, its gross asset value was €57.5m or €1.91 per share, a decrease of €0.19 from €2.10 per share at the end of December 2008.

The January mark-to-market variations of Volta Finance's asset classes have been: -3.3% for ABS investments, -5.2% for CDO investments and 1.2% for corporate credit investments. The decline in price of most assets held by the company led to another significant decrease in the GAV. This decline was once again due to the continual increase in the discount margin of structured credit products, following ongoing rating downgrades and defaults in the underlying assets in the midst of a worsening economic environment.

ISDA board takes on buysiders
ISDA's board of directors has elected three new members. For the first time in the history of the Association, buy-side (or non-dealer) firm members will serve on the ISDA Board. The three new directors are: Pierre-Emmanuel Juillard, head of structured finance division, AXA Investment Managers; Ted MacDonald, md and treasurer, the D. E. Shaw group; and Bill Powers, md and member of PIMCO's Investment Committee.

Juillard joined AXA Investment Managers in March 1999 as the head of structured credit and securitisation, and founded AXA Investment Managers' structured finance division (SFD). As the head of SFD, he also sits on the executive committee of AXA Investment Managers.

Prior to joining the D. E. Shaw group in 2003, MacDonald worked at Citadel Investment Group, where he was most recently a director in that firm's portfolio finance group. Finally, Powers works at PIMCO's Newport Beach office. Prior to joining PIMCO in 1991, he worked at Salomon Brothers and before that served as senior md specialising in MBS at Bear Stearns.

DTCC adopts Markit loan identifier system
The DTCC has adopted Markit's new entity identifier system for loans processed by Loan/SERV, DTCC's suite of services for the syndicated loan market. According to industry trade groups in Europe and North America, the inconsistent use and slow industry uptake of standard, unique identifiers have unnecessarily perpetuated operational risks in this market. The collaboration between Markit and DTCC's Loan/SERV marks a significant effort to remedy these deficiencies and enhance accuracy and efficiency in the processing of syndicated loans, the two firms say.

Markit's entity identifiers undergo a stringent validation process prior to loan issuance; therefore, use of the identifiers will enable Loan/SERV to perform position reconciliations using verified entities. Prior to this, obtaining reconciliation information from the agent banks was a complicated, manual process.

Ambac updates
Ambac Financial Group has announced a Q408 net loss of US$2.34bn, or a net loss of US$8.14 on a per-share basis. This compares to a Q407 net loss of US$3.27bn, or a net loss of US$32.03 on a per-share basis.

Ambac's president and ceo, David Wallis, says he is encouraged by the progress made in relation to some of Ambac's strategic initiatives. "We continue to place significant emphasis on de-risking our portfolio. The successful commutation of US$3.5bn of CDO of ABS exposures, including two CDO-squared deals, was constructive and we will continue to pursue this de-risking approach," he comments.

In relation to new business, Ambac reports that it is progressing towards the launch of its municipal-only financial guarantor - Everspan Financial Guarantee Corp. The company expects to begin doing business out of this company during the second quarter.

AC & CS 

MBIA hit by downgrades

A round up of this week's structured credit news

MBIA has been downgraded by both Moody's and S&P, following its announcement that it has segregated its municipal and non-municipal financial guaranty exposures into two separately capitalised operating companies (see last week's issue). The restructuring sparked concern about whether a credit event would be triggered (see separate News Analysis).

Moody's has downgraded to B3 from Baa1 the insurance financial strength ratings (IFSR) of MBIA Insurance Corporation and its supported subsidiaries, with the outlook developing. It also placed the Baa1 rating of MBIA Insurance Corporation of Illinois on review for possible upgrade.

S&P, meanwhile, lowered its counterparty credit, financial strength and financial enhancement ratings on MBIA Insurance Corp to triple-B plus from double-A (outlook negative). At the same time, the agency lowered its counterparty credit and financial strength ratings on MBIA Insurance Corp of Illinois (MBIA Ill) to double-A minus from double-A (credit watch developing) and lowered its counterparty credit rating on MBIA Inc to double-B plus from single-A minus (outlook negative). S&P also lowered its counterparty credit and financial strength ratings on Municipal Bond Insurance Assn to double-A minus from double-A (watch developing).

The downgrades reflect two factors. First, the guarantor's substantial reduction in claims-paying resources relative to the remaining higher-risk exposures in its insured portfolio, given the removal of capital, and the transfer of unearned premium reserves associated with the ceding of its municipal portfolio to MBIA Illinois. Second is the continued deterioration of the firm's insured portfolio of largely structured credit assets, with stress reaching sectors beyond residential mortgage-related securities.

From a future business production perspective, S&P believes that MBIA Ill's competitive position may suffer from legacy MBIA performance. In addition, there is uncertainty regarding investors' acceptance of the restructuring and ring-fencing plan.

The agency says it downgraded MBIA because of its view that its retained insured portfolio lacks sufficient sector diversity and with time could become more concentrated. In addition, the company's 2005-2007 vintage direct RMBS, ABS CDO and other structured exposures are subject to continued adverse loss development that could erode capital adequacy. Supporting the debt-service needs of the holding company might also place pressure on capital adequacy.

The negative outlook on MBIA reflects the agencies' view that adverse loss development on the structured finance book could continue. A revision of the outlook to stable will depend on greater certainty of ultimate potential losses, as well as the orderly run-off of the book of business.

Ratings on MBIA Ill could be raised if it successfully raises capital and credibly ring-fences its operations from MBIA. However, any rating action based on these factors would most likely remain within the double-A category. If MBIA Ill is not able to raise capital or if legal challenges impair management's restructuring efforts, the ratings could be lowered.

MBIA Corp paid to National approximately US$2.89bn as a premium to reinsure the policies covered by the reinsurance and assignment agreements. MBIA Corp received a 22% ceding commission on the unearned premium reserve. In addition to the US$2.89bn, National has been further capitalised with US$2.09bn from funds distributed by MBIA Corp to MBIA Inc as a dividend and return of capital, which MBIA Inc in turn contributed through an intermediate holding company to National.

iTraxx rule changes introduced
Markit iTraxx dealers have voted to change two rules governing the iTraxx Europe indices in order to make them more reflective of the current economic environment. The new rules will come into effect before the index rolls into series 11 on 20 March.

The first rule change raises the maximum cut-off level for inclusion in the iTraxx Europe Crossover from 25% upfront plus 500bp running spreads to 50% upfront plus 500bp running spreads, in line with the spread widening seen across the market. The second rule change states that the constituents of the iTraxx Europe Main index must comprise 30 entities from the auto and industrial sectors combined, instead of 10 from the auto sector and 20 from the industrial sector as previously required. The change is designed to ensure that only the most liquid entities are selected for inclusion in the index.

CDPC's ratings downgraded, withdrawn
Moody's has withdrawn the counterparty rating and debt ratings of Primus Financial Products, at the request of the CDPC (see SCI issue 123). The ratings were each also downgraded immediately prior to withdrawal.

Primus' counterparty rating was downgraded from A1 (on review) to Ba2, while the Series A, 2005 Series A and 2005 Series B subordinated deferrable interest notes were downgraded from A1, A2 and A2 to Ba3, B1 and B1 respectively. At the same time, the NC-10 preferred securities were downgraded from A3 (on review) to B2.

Moody's notes that the downgrades 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 corporate synthetic CDOs (see last week's issue); and (ii) further deterioration in the credit quality of Primus Financial's CDS reference portfolio since the last rating action.

RMBS Issuer Principles announced
The European Securitisation Forum (ESF) has released its 'RMBS Issuer Principles for Transparency and Disclosure', a set of voluntary guidelines for issuers of European RMBS. The principles are an important component of the industry's initiatives to increase transparency in the securitisation market, as recommended by ECOFIN, European Commission, Financial Stability Forum, IOSCO and other bodies.

The principles will apply to disclosure of information by issuers to investors and other market participants, both pre-issuance and post-issuance, on a regular reporting/ongoing basis. The objective is to establish a standard of consistency, transparency and data accessibility expected by investors, and to enhance comparability of reporting across Europe. The initiative is part of a coordinated global effort together with the ASF's Project RESTART.

Version 1.0 of the principles encompasses all RMBS secured by prime and non-conforming mortgage loans originated by European Economic Area-based issuers, whether issued under standalone or revolving structures, including master trusts. They recommend that issuers comply with the reporting of a required high percentage of industry-agreed data fields by the end of 2009 to allow issuers sufficient time to complete required information systems changes.

Additionally, the principles propose a new combined uniform Credit Rating Agency Reporting Template for the minimum information to be provided by issuers to credit rating agencies in respect of UK non-conforming RMBS. The credit rating agencies have indicated that they will start to include the template in their information gathering processes for new UK non-conforming RMBS transactions closing as from 31 March.

Issuers are in various stages of evaluating and implementing the new principles. Banks that have already agreed to endorse the principles are: Abbey National, Barclays Bank, Bradford & Bingley, GMAC-RFC UK, HBOS, Investec, Lloyds TSB, Nationwide, Paragon Group, RBS, Obvion and SNS Bank.

ICE details European CDS CCP plans
ICE has released further details of its plans to launch a European CCP for CDS (see last week's issue). The new service will be called the ICE Trust Europe, operating within the existing ICE Clear Europe clearing house which is regulated by the UK Financial Services Authority.

ICE Trust Europe will have a segregated risk pool and dedicated risk management systems for the European credit derivatives market, including a separate guaranty fund and margin accounts. It is anticipated that the use of ICE Trust Europe will offer efficiency and a common market infrastructure to global CDS market participants. A first-half 2009 launch is expected.

Subject to necessary regulatory approvals, it will leverage the clearing technology and risk management processes currently in development. ICE Trust Europe is establishing governing rules and operating procedures appropriate for European CDS clearing, including membership and margining requirements.

Homeowner Affordability plan leaves questions unanswered
The Obama Administration announced last week its Homeowner Affordability and Stability Plan, which forms the backbone of a comprehensive housing and mortgage reform plan aimed at helping borrowers and supporting the US housing market. However, while an extensive amount of data was released, plenty of questions are yet to be answered, according to ABS analysts at Barclays Capital.

Their initial analysis of the plan indicates that refinancing opportunities for agency mortgage borrowers should help four to five million borrowers, mainly in hybrid ARMs and 30-year loans. "From a pre-pay standpoint, 2006-2008 premiums should speed up significantly. As for valuations, down-in-coupon should outperform, the call protection (and pay-ups) for credit-impaired pools should diminish, 30/15-year swaps should underperform, while GN premiums should outperform FN/ FH premiums," they add.

Moreover, the US$75bn initiative to help stem foreclosures and increase loan modifications (rate modifications, not principal reductions) has incentives for servicers, borrowers and lenders. On the valuation front, the plan should be a mild positive for sub-prime and Alt-A mortgages, as well as lowering the tail risk in jumbo loans. The more significant impact might be on the housing front, if the programme manages to minimise deliberate defaults, increases modifications and prevents future REO supply.

And the increased government support for the GSEs should not only lower concerns about GSE credit risk (by increasing the preferred stock limits), but should also be a mild positive in terms of demand from GSE portfolios, the analysts say. The US Treasury will increase its Preferred Stock Purchase Agreement to US$200bn from its initial participation of US$100bn in each of the GSEs. Furthermore, the retained portfolios for each of the GSEs will be permitted to grow to US$900bn each by the end of 2009.

FASB launches new fair value projects
Robert Herz, chairman of FASB, has announced the addition of new FASB agenda projects intended to improve both the application guidance used to determine fair values and the disclosure of fair value estimates. The projects were added in response to recommendations contained in the SEC's recent study on mark-to-market accounting, as well as input provided by the FASB's Valuation Resource Group.

The projects on application guidance will address determining when a market for an asset or a liability is active or inactive; determining when a transaction is distressed; and applying fair value to interests in alternative investments. The project on improving disclosures about fair value measurements will consider requiring additional disclosures on such matters as sensitivities of measurements to key inputs and transfers of items between the fair value measurement levels.

FASB anticipates completing projects on application guidance by the end of Q209 and the project on improving disclosures in time for year-end financial reporting.

"The SEC expressed continued support of fair value accounting in its study, but recommended consideration of potential improvements in the guidance surrounding the application of fair value principles," states Herz. "We agree with the SEC and with our Valuation Resource Group that more application guidance to determine fair values is needed in current market conditions. Additionally, investors have asked for more information and disclosure about fair value estimates. Therefore, the FASB is immediately embarking on projects that directly address areas that constituents have told us are challenging in the current environment, and which will improve disclosures in financial reports."

Smurfit prices determined
The prices determined by the credit event auctions conducted to facilitate settlement of CDS and LCDS trades referencing Smurfit-Stone Container Enterprises were 8.875% and 65.375% respectively. The final prices represent the recovery rate used to cash settle credit derivative trades. Protection sellers compensate protection buyers for the loss on defaulted obligations by making a payment equal to par value minus the recovery rate.

Smurfit CDS and LCDS registered inside market mid-points (IMMs) of US$7.875/US$68.25 and a US$128.675m/US$40m net open interest to sell. Structured credit analysts at Barclays Capital point out that both LCDS and CDS average recoveries have fallen dramatically in 2009, compared with the previous year.

"Importantly, all auctions have typically had an open interest to sell bonds, implying that auction participants are net sellers of CDS protection and are often looking to sell bonds held in a basis package," they note. "Lastly, comparing the IMMs and the final price, we conclude that the number of limit bids have always been sufficient to absorb all the open interest to buy or sell."

WMBA defends OTC derivatives
The Wholesale Market Brokers Association (WMBA) says it firmly rebuffs the statement recently reported in press coverage of the submission by the Federation of European Stock Exchanges that "unregulated over the counter (OTC) markets were at the core of the recent crisis" and that OTC markets are unregulated.

The Association stresses that primary regulatory focus in OTC markets is on the participants themselves based on their activity, the nature of their counterparties and type of assets involved. "It is misleading to suggest that the exchange-traded markets have a more robust regulatory model. Instances of market failure can also be found in the exchange-traded model, therefore implying that it is the individuals or organisations that should be the focus of supervision, as is the case in the OTC markets."

The WMBA adds that there is a danger that policy decisions are being considered that may attempt to force OTC products onto exchanges, resulting in a dramatic reduction in liquidity and product flexibility in markets essential for trading and hedging. It says it strongly supports the move towards a central counterparty (CCP) as the most effective step that can be taken to improve the settlement of CDS and other OTC products generally. Further, it acknowledges that regulatory changes will be a response to the crisis, but underlines that the focus should be on the regulation of market participants and not the mandating of monopolies in the execution of financial products.

The OTC mode of execution of transactions is fully compatible with the well-publicised industry-wide benefit of reduced counterparty exposure for market participants. The WMBA continues to endorse completely industry steps toward these CCPs becoming operational.

Trading venue expands into LP interests
Illiquid asset marketplace SecondMarket has expanded into trading in limited partnership (LP) interests in private equity funds, venture capital funds, hedge funds and funds of funds (see SCI issue 123). Through SecondMarket, limited partners will have the opportunity to monetise their stakes even when a fund has no formal redemption programme or has restricted redemptions, the firm says.

The platform will also enable limited partners in private equity and venture capital funds to transfer their future capital commitments to investors that are better able to satisfy these obligations. Over 150 of SecondMarket's existing market participants have expressed interest in purchasing LP interests and the marketplace already has nearly half a billion in LP interests listed for sale.

"Today, many limited partners are in need of capital or have a desire to rebalance their portfolios," explains SecondMarket ceo Barry Silbert. "However, many are locked into their positions for years or are unable to receive capital distributions due to redemption restrictions. A centralised and transparent market, operating in close coordination with the funds themselves, is necessary to enable these limited partners to sell their positions."

In addition to trading LP interests, SecondMarket operates markets for auction-rate securities, bankruptcy claims, restricted securities and blocks in small capitalisation companies. It plans launch trading capabilities for CDOs and MBS in Q109.

Hedge fund supervisory disclosure supported
The Alternative Investment Management Association (AIMA) has revealed a major new transparency initiative. AIMA says that it will support the principle of full transparency and supervisory disclosure of systemically significant positions and risk exposures by hedge fund managers to their national regulators.

The initiative is one of a series of policy positions in the association's new platform. Other key new strands of the platform include an aggregated short position disclosure regime to national regulators, support for new policies to reduce settlement failure (including in the area of naked short selling), a global manager-authorisation and supervision template based on the model of the UK's FSA and a call for unified global standards for the industry.

AIMA is representing the global hedge fund industry in on-going international discussions about the future regulatory framework for the industry, notably with the organisations tasked by the G20 to address the issue, such as IOSCO and the Financial Stability Forum. It is also working closely with leading national regulators regarding the supervision of hedge fund managers.

Andrew Baker, chief executive of AIMA, comments: "We want to dispel once and for all this misconception that the hedge fund industry is opaque and uncooperative. That's why we are declaring our support for the principle of full transparency of systemically significant positions and risk exposures by hedge fund managers to their national regulators through a regular reporting framework. We are confident that our members recognise that it is in everyone's best interests if we cooperate fully in the important on-going international efforts to examine and improve the supervisory framework of the future."

Seasonal effects to slow ABX delinquencies
Delinquencies are generally expected to rise in the upcoming February ABX remits, due to recent deterioration of roll rates and lower day count. Despite this, favourable seasonal effects should keep the growth of delinquencies slower than those of last month, according to analysts at Barclays Capital.

For example, serious delinquencies are anticipated to increase by 40bp-50bp for the 06 series and by 140bp-190bp for the 07 series, a slightly smaller rise than last month.

In addition, with two fewer business days in February versus January and a shrinking REO bucket, CDRs should decline slightly by 20bp-50bp for the 06 series and post a moderate increase of 20bp-100bp for the 07 series this month. Despite fewer days, voluntary prepayments should benefit from the rate rally and stay relatively unchanged on 06-1 and 07-1 series, while posting slight increases on 06-2 and 07-2 series as they approach the 3/27 and 2/28 first rate resets.

Brazil tops sovereign CDS liquidity table
Fitch Solutions' latest Global Liquidity Scores commentary shows that Brazil continues to dominate liquidity in the sovereign CDS market. The global economic downturn reduced Brazil's budget surplus from BRL15bn in January 2008 to only BRL4bn in January 2009.

South Korean banks continue to dominate liquidity in the Asian corporate sector, accounting for four of the top-five liquid CDS contracts. ICICI Bank entered the top five last week amid concerns about its exposure to a number of Indian corporate clients, which are under financial pressure.

Meanwhile, telecoms continue to dominate liquidity in the European CDS market, with Telekom Austria entering the top-five table. The Austrian government is reportedly considering selling its 27% stake in Telekom Austria this year, resulting in numerous potential M&A options in the industry.

2009 rally 'overdone'
The rally in the European ABS and RMBS secondary markets since the beginning of the year was 'overdone', according to structured finance analysts at Deutsche Bank. They expect spreads to continue to soften in the coming weeks. Indeed, benchmark names have already begun to widen, as fears over a rapidly deteriorating global economy and bank nationalisation pervade.

"In European ABS, the lack of depth in bid-side liquidity was all too apparent last week as the rally of recent weeks faded and vanilla spreads widened some 25bp-50bp," the strategists comment.

ABS CDOs downgraded
Moody's has downgraded a further 133 notes issued by 27 CDOs that consist of significant exposure to Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. The agency has also downgraded its ratings of 236 notes issued by 55 CDO transactions that have significant exposure to ABS and corporate names (as well as confirming the ratings of four notes).

Moody's says its actions reflect certain updates and projections on these asset classes.

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

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

Bumper German SME CLO rated ...
Moody's has assigned definitive ratings to two tranches of a €4.7bn German SME CLO issued by S-FIX 1. This is a true sale transaction of a portfolio of company loans amounting to €5.3bn at closing.

The portfolio is originated by LBBW and servicing will also remain with the bank in the future. The average loan size is €2.8m and the average portfolio amount per debtor group is €5.1m.

The portfolio consists of loans (including syndicated loans) to mainly German business clients of LBBW across different industries. All loan agreements are governed by German law.

... while Greek SME CLO prices
EFG Eurobank has closed Anaptyxi SME II 2009-1, a €3.3bn retained balance sheet CLO. The five-year revolving pool comprises Greek SME and corporate loans, concentrated in the non-auto wholesale trade (30.1%) and construction and real estate (12%) sectors. The A1 rated five-year Class A notes priced at 80bp over Euribor and the unrated Class Bs at 95bp over.

Subordinated ...
Fitch has downgraded US$6.5bn from 14 CRE CDOs, reflecting the agency's view on industry and vintage concentration risks outlined in its revised structured finance CDO rating criteria released on 16 December 2008. All classes were assigned stable outlooks, reflecting Fitch's expectation that the ratings will remain stable over the next one to two years.

These 14 transactions are primarily backed by portfolios of the most junior tranches of CMBS transactions. Downgrade actions in some cases were a full three categories, with a total of 164 classes downgraded. In general rating actions were more severe on eight CDOs that had more recent vintage collateral and a Fitch derived weighted average rating (WAR) in the triple-C category, compared to the five CDOs that had more seasoned collateral and a Fitch derived WAR in the BB/B category.

Approximately 22.9% of the rated bonds by dollar amount remained investment grade. After the downgrades, of the US$1.6bn of previously triple-A rated securities, 20.2% remain at that level, 15.6% are downgraded to the double-A category, 18.4% are downgraded to the single-A category, 30.7% are downgraded to the triple-B category and 15.1% to the double-B category.

... and mezz CRE CDOs downgraded
Fitch Ratings has also downgraded US$1.8bn and affirmed US$0.8bn from nine CRE CDOs. These nine transactions are primarily backed by portfolios of the mezzanine tranches of CMBS transactions and other commercial real estate related debt, none of which was issued in 2006 or 2007 (Vintage 1).

These rating actions reflect Fitch's view on industry and vintage concentration risks outlined in its revised Structured Finance CDO rating criteria released December 16, 2008. All classes were assigned Stable Outlooks reflecting Fitch's expectation that the ratings will remain stable over the next one to two years. Outlooks were not assigned to classes in any single-C category.

Rating actions for senior classes of these transactions were less severe than recent actions taken on CRE CDOs due to the absence of recent vintage collateral, capital structures that have delevered, and a relatively short weighted average term to maturity. These transactions were issued between 2002 and 2004. Nevertheless, rating downgrade actions in two cases were more than two full categories lower, with a total of 60 classes downgraded and nine classes affirmed.

SIV wound down
S&P has withdrawn its issuer credit rating on Abacas Investments and its issuer credit ratings on the SIV's CP and MTN programmes. The rating withdrawals follow Abacas' repayment in full of all its rated obligations and the subsequent wind-down of the vehicle.

US CDS indices widen significantly
Based on credit default spreads measured in S&P's CDS indices, spreads for entities across the investment grade and high yield arena have experienced significant widening. Last week, index spreads for the S&P 100 CDS Index fluctuated between 122bp and 130bp, closing yesterday at 130bp. The S&P 100 CDS Index has had a positive year to date return of 0.57%, while the equity index has fallen by 14.5%.

Meanwhile, index spreads for the S&P CDS US Investment Grade Index fluctuated between 286bp and 300bp, closing yesterday at 299bp. The S&P CDS US Investment Grade Index Series 1 has had a year to date total return of 0.99%.

Index spreads for the S&P CDS US High Yield Index fluctuated between 1272bp and 1327bp, closing at 1313bp. The index's highest spread this year was 1327bp on 18 February. The High Yield Index has had a year to date total return of -2.45%, reflective of a year to date increase in index spread of 108bp.

IFSB adopts new standards for sukuk
The Council of the Islamic Financial Services Board (IFSB) has recently adopted two new standards. The first is 'Guiding Principles on Governance for Islamic Collective Investment Schemes' (IFSB-6) and the second is 'Capital Adequacy Requirements for Sukuk Securitisations and Real Estate Investment' (IFSB-7).

The two documents complement the existing IFSB Standards, namely the 'Capital Adequacy Standard for Institutions offering only Islamic Financial Services' (IFSB-2) and the 'Guiding Principles on Corporate Governance for Institutions offering only Islamic Financial Services' (IFSB-3), which were issued in 2005 and 2006 respectively. IFSB-7 deals with aspects relating to regulatory capital requirements for sukuk that are not covered in the IFSB-2.

These are: capital requirements for institutions offering Islamic financial services (IIFS) that are holders of sukuk that do not represent the holder's proportional ownership in an undivided part of an underlying asset (or pool of assets) where the holder assumes all rights and obligations attached to such an asset or pool of assets; and the capital treatment of securitisation exposures (i.e. the exposures of an IIFS where it is, or acts in a capacity of, an originator, issuer or servicer of a sukuk issuance). The standard deals with the conditions that need to be met in order for securitisation exposures to be derecognised or minimised, as well as for the capital treatment of such exposures by IIFS upon their occurrence.

This standard applies to both originating and issuing IIFS (including originating IIFS that invest in sukuk that they themselves originate). For real estate investment, this standard deals primarily with the capital requirements for an IIFS that invests its own funds in real estate investment activities. In addition, the standard stresses the need for the authorities supervising IIFS to set appropriate threshold limits for IIFS that have real estate investment activities and financing activities involving real estate exposures.

CDS not triggered by LT2 deferral
Extension risk was highlighted once again last week, when Bradford & Bingley announced that the UK Treasury had amended its Transfer Order, thereby allowing the bank's LT2 to defer £850m of coupon payments. The move sparked speculation as to whether it constitutes a CDS trigger event for subordinated CDS under restructuring credit event language, which was swiftly quashed.

ISDA declared that the Transfer Order doesn't change the ranking and, although it changes the quantum LT2 can expect to receive in liquidation, that is not considered as subordination. However, ISDA indicated that the next time B&B does not pay a coupon and it's considered to be because of credit deterioration, it could constitute a trigger event under restructuring.

New LFA/STD for CDO
Jazz III CDO entered into a new liquidity facility agreement (LFA) with Deutsche Bank and a supplemental trust deed (STD) on 13 February. The initial LFA executed at closing with Rabobank International has expired and was not renewed, while the STD introduces other amendments related to counterparties' rating triggers.

Moody's says that these amendments do not affect the mechanisms on which its analysis relied to assign the transaction's initial ratings. The agency believes that the appointment of the new liquidity facility provider and that the amendments subject to the STD do not have an adverse effect on these ratings.

More CSOs downgraded
Moody's has downgraded its ratings of 169 notes issued by 50 CDOs that reference a portfolio of corporate entities. The rating actions are the result of: the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of CSOs; and the deterioration in the credit quality of the transaction's reference portfolio.

AIG to tap Fed again?
Speculation that AIG has asked the Fed to re-engineer its bailout package (for the third time) has underscored what some observers have suspected for some months - that assets sales at AIG won't be sufficient to repay its state aid. The market is expecting AIG to announce another significant quarterly loss imminently (mooted to be around US$35bn).

Conversion of government preferreds to equity is reportedly being discussed, but that appears to hold little logic for the US government as it already has an 80% ownership stake. Analysts suggest that some form of debt/equity swap is likely to occur, but that there is hesitation around triggering CDS. AIG CDS moved back to trading points up-front on Monday.

UK Banking Act heightens regulatory risk
Regulatory risk is looks set to continue to be a concern for investors throughout the current downturn. Indeed, the UK Banking Act 2009 is being seen as the latest such example, as it increases the potential for intervention in securitisation and covered bond transactions.

The act empowers UK authorities to take a number of actions in relation to financial institutions that are in, or likely to encounter, financial difficulties. According to Fitch, the power is widely drafted and includes the provision to modify common law and statutory provisions, without the need for prior approval of parliament. It also allows them to transfer covered bond obligations to a new entity.

Non-conforming RMBS performance continues to decline
Fitch says in a new report that the performance of UK non-conforming RMBS continues to deteriorate, with higher levels of arrears, repossessions and losses.

As house prices continue to fall, the performance of collateral pools within UK non-conforming RMBS transactions has continued to deteriorate. Loans currently in arrears by three months or more rose by 20.9% to 15.9% in Q408 from 13.2% in Q308. In addition, the number of properties being repossessed has accelerated, with the number of loans currently in repossession increasing by 33.6% to 3.56% of the current outstanding balance of all loans, up from 2.7% in the previous quarter.

The deteriorating performance resulted in 265 tranches being downgraded during 2008, although this has predominantly been to low investment grade and sub-investment grade ratings. "Repossessed properties are being sold into a difficult market of falling prices and low demand, resulting in both a lower sale price and also an increased cost of carry. This can clearly be observed in the reported loss severity figures for UK non-conforming transactions," says Peter Dossett, associate director in Fitch's RMBS surveillance team.

Ratings unaffected by indenture changes
Moody's says the ratings currently assigned to ACA CLO 2005-1 will not, at this time, be reduced or withdrawn solely as a result of the implementation of an amendment to its indenture dated as of 24 February 2009. At the same time, ratings on Apidos CDO I will not be reduced or withdrawn solely as a result of the implementation of an amendment to its indenture dated as of 23 February.

The supplemental indenture allows the issuer to establish tax subsidiaries solely to hold and administer certain securities (such as equity interests in a partnership) it may receive in a bankruptcy proceeding or private workout, and is designed to ensure that the issuer will not be deemed to be engaged in a US trade or business as a result of an exchange of collateral obligations for such workout securities.

ACA CLO 2005-1 is a high yield cash flow CLO managed by Apidos Capital Management. The last rating action on ACA CLO 2005-1 occurred on 16 August 2005 when the transaction was originally rated.

Meanwhile, Apidos CDO I is a high yield cash flow CLO managed by Apidos Capital Management. The last rating action on Apidos CDO I occurred on 4 August 2005 when the transaction was originally rated.

CS & AC

Trading

Trading ideas: plain and simple

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on Plains All American Pipeline

Heading into the end of 2008, energy credit spreads widened along with the precipitous drop in crude and natural gas prices. We felt that the extensive widening was overdone and advised clients to maintain a long bias to the sector, which has paid off well, as the median energy credit spread tightened by 109bp. With that in mind, we still find long opportunities within the sector and we highlight Plains All American Pipeline as a solid credit to take a long position in.

Though the company is exposed to the volatile commodity market, we find that its largely fee-based income reduces its earnings volatility, making it a solid play. Plains All American Pipeline's equity-implied factors are some of the best in the entire energy sector.

Its three-month at-the-money equity-implied volatility is a minimal 36%, which is one of the lowest in the entire non-financial universe. Exhibit 1 shows a time series of its three-month implied volatility relative to its five-year credit spread. Its implied vol is now back to pre-Lehman bankruptcy levels; however, its credit spread still has a ways to go.

The low expected earnings volatility implied from the equity derivatives market gives us confidence in the company's ability to generate consistent cash in a difficult market. This, combined with plenty of available credit on existing loan facilities and a fee-based business, leads us to recommend selling protection on the credit.

Exhibit 1

We see a 'fair spread' of 226bp for Plains All American based upon our quantitative credit model. The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit).

Plains' implied volatility, equity-implied default probability and accruals are extremely strong relative to peers. Our credit model turned bullish on Plains' credit spread in October 2008 when its spread jumped from 200bp to near 600bp in a matter of days. Exhibit 2 shows a time series of Plains' spread and expected spread, and the current difference remains greater than 220bp.

Exhibit 2

Sell US$10m notional Plains All American Pipeline 5 Year CDS protection at 410bp.

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).