Contents

Distressed assets

PPIP revealed

Initiative could cause more pain in the short term

Further details of the US Treasury's public-private investment programme (PPIP) received a wary welcome this week. However, structured credit practitioners have warned that the initiative could result in more pain in the short term, in the form of further write-downs for participating banks.

The US Treasury's proposal, announced on Monday (23 March), comprises two elements - a legacy loans programme and a legacy securities programme - and will see US$75bn-US$100bn in TARP funds committed in order to generate US$500bn in purchasing power, with the potential to expand to US$1trn "over time". The legacy loans programme will allow real money investors to participate in public-private investment funds (PPIFs) that will combine their capital with Treasury capital and FDIC financing in order to bid on pools of bank loans. The FDIC will issue collateralised debt to finance the programme.

The legacy securities programme will allow a number of selected asset managers to combine private capital with Treasury capital and bid for eligible non-agency RMBS and CMBS held by financial institutions, and apply to TALF for further financing. The Treasury expects to approve five managers under the securities programme. Sources indicate that this leg of the plan is likely to be more successful than the loans leg due to the bigger disconnect between where loans are marked and the level of the levered bid.

Hansol Kim, founding partner of Pinelakes Capital, comments that, while the programme changes the dynamics on the buy-side, it does little to address issues on the sell-side - i.e. the sellers' unwillingness to sell at a level lower than where they have their assets marked. "There is little incentive for the banks holding the assets to sell, given that the gap between the bid and the offer will remain too wide, in my opinion," he says. "Leverage offered to the investors from the PPIP may incentivise buyers to submit a slightly higher price for the assets, but I doubt it will be high enough."

He adds: "In the short-term, the PPIP could even cause more pain for banks. To the extent that a meaningful amount of these legacy assets trade hands, it may become clear to everyone how big the gap is between the current marks and the actual trading levels. It will become exponentially difficult for banks to continue to mark similar legacy assets at the higher levels - resulting in further write-downs."

According to Mehernosh Engineer, senior credit strategist at BNP Paribas, the crux of the problem today with legacy assets is that hedge funds are willing to pay around 30c for triple-A sub-prime assets (as indicated by the Markit ABX index), but banks holding them are asking for 60c. He suggests that the PPIP, through its complexity, intends to provide 60c to banks while offering 30c to private investors, with the FDIC (read taxpayer) taking the 30c loss provided via subsidised lending and leverage.

The FDIC intends to provide as much as 6x of leverage to private investors, essentially requiring them to put up only 7c of equity capital, with 7c coming from the treasury. With hedge funds being provided with subsidised lending rates (the buyer would receive financing by issuing debt guaranteed by the FDIC), private investors can bid almost 100% above the fair value price and transfer the loss to the FDIC, Engineer notes.

For example, a triple-A tranche with US$100m in notional value trading at 30% can be bid as high as 60%, if 10% subsidised lending is provided to private investors over the life of the asset (typically five years). In this case, investors put up 4.2%, the treasury puts up 4.2% and 51.6% is borrowed from the FDIC to buy the asset at 60% from the bank.

"This is an extremely lucrative trade for private investors as, under normal circumstances, the prime broker would provide no leverage on a distressed asset - and certainly not at FDIC-guaranteed rates. Why would a private investor not sign up for such a scheme, where there is socialisation of losses and privatisation of gains?" asks Engineer.

He suggests that the treasury will insist that a fair auction process is being held, where the highest bidder receives the asset, but in reality the bidder with the biggest subsidy and leverage will receive the asset and the tax payer stands to take significant losses.

ABS analysts at Barclays Capital estimate that investors could earn around 20% ROE under the programme from carry alone (providing the asset performs as expected), with such overly attractive terms eventually causing asset prices to inflate. They suggest that any upside gained from selling positions that are marked-to-market can be used to offset write-downs of other bonds that haven't been marked-to-market - albeit such a process is unlikely to be applicable to an entire portfolio, especially if it contains sub-prime exposures.

Meanwhile, others in the industry have suggested that expanding the legacy assets to include stronger ABS that are loosing value due to lack of liquidity would have more success in the short term. Carol Bunevich, md at Fieldstone Capital, notes that student loan ABS, for example, would really benefit from being eligible.

"A good proportion of the older FFELP transactions have a 97% government guarantee and are very strong deals," she says. "But, due to the lack of liquidity, they are being bid in the 70s. If investors were given the financing to buy these deals, a better bid/offer margin would be possible and we would be closer to a successful situation."

Whether for or against the programme, industry participants agree that the initiative will not present a quick fix for the economic situation. Gene Yeboah, former head of credit structuring and strategic risk management at Schroders, reckons that the real economy is going to suffer for many years - way beyond 2009 - but believes the US Treasury's approach is the correct one.

"The banking system needs to be delevered and fundamentally there are only two ways to delever: either by lowering the total debt (i.e. selling off assets in the form of debt) or by increasing the size of equity via capital infusion, like what Paulson initially proposed," he says. "It seems to me that the former approach is a lot more practical and would yield results faster than the latter. However the size of the sold called toxic debt is much higher than what the Treasury is proposing."

Barclays Capital estimates that the legacy assets on banks' balance sheets total around US$2.7trn (including around US$1.1trn of non-agency RMBS and CMBS) in market value, and suggest that US$1trn of purchasing power may not be enough.

AC & CS

Investors

Expansion fever

Hedge funds look to future TALF changes

A number of hedge fund managers have already begun preparing for potential future changes in the TALF programme, given that the triple-A consumer ABS segment isn't typically where they participate. The move is in anticipation of the programme's expansion into corporate and mortgage assets, as well as the potential inclusion of lower ratings.

"There is US$1trn to spend and triple-A ABS is a specialised sector from a risk/return perspective, so there is certainly potential for demand to lead government action in this direction," confirms one fund of funds manager.

He adds that the TALF opportunity is binary for the buy-side: either a manager is an expert in ABS and has a client base focused on triple-As or they don't. "It's a niche opportunity and requires the conviction that consumer credit risk is bottoming out (which I personally believe isn't the case yet)."

Additionally, the programme's disclosure requirements and risk management issues - both in terms of the mismatch of the assets and the loan, as well as the tenor of a hedge fund's own capital and the TALF liabilities - have served to dissuade many potential investors from participating. "The fact that the TALF loan maturity is shorter than the typical life of the underlying means that secondary market trading of these assets will be impaired. Hedge funds are still facing redemption pressure, so appropriate exit strategies remain a priority," the manager explains.

Indeed, timing remains an issue for investors entering this space (SCI passim), with the early movers in the crisis having been shown to have perhaps acted prematurely. For example, the third-party equity positions in the Bear Stearns and UBS portfolios - which BlackRock won the mandates for - are understood to have incurred losses.

"No-one's denying that there are likely to be new portfolio mandate opportunities within the government-sponsored context, but the market is struggling for signposts as to timing," the manager agrees. "Few buy-siders are embracing TALF as an investment strategy: the uncertainty associated with participation is currently too high. The political climate is such that direct exposure to government largess is becoming expensive."

Against this backdrop, Barclays Capital and JPMorgan are said to have established regulatory arbitrage vehicles to insulate secondary investors in TALF-eligible deals from certain reporting requirements.

Meanwhile, the levels at which TALF-eligible deals priced last week should encourage bank issuers to re-enter the primary ABS market, according to structured credit analysts at JPMorgan. A total of US$8.2bn in TALF-eligible ABS was issued for the first round of the programme, which included US$5.2bn of prime auto loan ABS from Nissan, Ford and Huntington Auto Trust, and a US$3bn credit card ABS from Citi.

The US$3bn credit card transaction - CCCIT 2009-A1 - priced at 175bp over one-month Libor, substantially tighter than indicative secondary spreads of 340bp, and offered leveraged yield of around 14%. "At these levels, we expect that bank issuers would be much more willing to re-enter the ABS market for the funding diversification and off-balance capital relief," the JPMorgan analysts note.

According to ABS analysts at Wachovia Securities, the TALF programme has provided the mechanism to get buyers and sellers back together again. "Issuers had a significant backlog of receivables to securitise and credit investors had capital to invest," the analysts observe. "What was lacking was a level of confidence that would allow market transactions to proceed. The TALF programme provided that foundation; as a result, most deals were reported to be oversubscribed."

Although new issue spreads were tighter than recent secondary levels, substantial tiering among issuers remains, with investors differentiating between seller/servicers. It still remains to be seen how TALF-eligible deals will trade in the secondary market, however.

The fund of funds manager observes that the market is experiencing a bit of a 'back to the future' moment under TALF. "We're essentially returning to the rating agency-endorsed securitisation model, with high leverage multiples and standalone SPV or master trust structures."

While in the short term the TALF programme is likely to introduce new capital for more loans, in the long term the market will see continued deleveraging. "Ultimately, the securitisation model faces greater challenges - large ticket investors no longer exist and others still have to be persuaded about the creditworthiness of the securities, so how much fundamental demand for the product is really there?" the manager concludes.

CS

Documentation

Close-out conundrum

Court action provides some clarity for derivatives documentation

The inability of the Lehman Brothers bankruptcy estate to access the value of in-the-money swaps in Lehman's favour has raised documentation concerns. Subsequent actions by the US bankruptcy court are nonetheless expected to influence how counterparties handle close-outs in future bankruptcies.

The Lehman estate took the position that, as its counterparties weren't exercising their termination rights under section 2(a)(iii) of the 1992 and 2002 ISDA Master Agreements, they had live contracts and so decided to assign them under the US bankruptcy code. Because the position is in-the-money for Lehman it has value for the new counterparty, so they would be prepared to pay for the assignment.

But this meant that the original counterparties were facing an unknown new counterparty, albeit one with minimum standards of creditworthiness as decided by the court. Consequently, the original counterparties were forced to decide whether they really wanted to keep the trade after all and a substantial number closed out, willing to take the risk of the market reimbursing them with the mark-to-market value rather than facing an unknown counterparty.

This assignment and assumption process is likely to influence how counterparties handle close-outs in future bankruptcies, according to Joshua Cohn, partner at Allen & Overy in New York. "The court has provided helpful clarifications in demonstrating its assignment powers and in terms of expressly leaving the option open to parties to close out rather than risk assignment," he explains.

He continues: "One could argue that case law under the bankruptcy code states that one can only use the safe-harbour right to terminate derivatives contracts, if one does so promptly. But the court allowed counterparties to close out even though it was months after the bankruptcy filing: it has essentially given a fair warning that if a counterparty stands behind section 2(a)(iii), they may be assigned or they may be unable to close out. This flexible outcome regarding close out may never happen again, so a counterparty should treat their rights under section 2(a)(iii) gingerly."

But some contracts weren't easily reassigned (because, for example, they were significantly off-market or no alternative counterparties were interested), so a pool of open transactions remains. Cohn says that this points to the question of how the US bankruptcy court will ultimately treat the stalemate issue under section 2(a)(iii) and whether it finds a way of accessing the value of those contracts.

Under the terms of the contracts, the Lehman companies usually can't assign the contract without the consent of the original counterparties, so they need a court order to allow the transfer (essentially overriding the contractual agreement for those counterparties that don't provide their consent). A hearing is scheduled for 3 June, but - given that the hearing has previously been postponed several times - there is some doubt as to when it will actually go ahead.

Jeremy Jennings-Mares, capital markets partner at Morrison & Foerster, notes that - if the hearing takes place and a judgement is given in favour of the Lehman companies - one interesting question is how the decision under New York law will relate to contracts governed by English law. "There is significant doubt as to whether the judgement will be recognised in the English courts, given the number of tricky conflicts of law issues involved. Certainly the market needs further details about how the proposal will work and so the hearing should help to clarify the situation."

An associated concern for the market is in connection with the risk of levy of default interest for those positions that are closed out late.

The case of Enron Australia versus TXU Electricity [2003] NSWSC 1169 (24 December 2003) was the first where a non-defaulting party in a derivatives contract used the insolvency of the other party as an excuse not to make payment under section 2(a)(iii). TXU had a net mark-to-market liability to Enron under 78 contracts of approximately A$3.3m, but the court recognised TXU's ability to rely on the flawed asset provision of section 2(a)(iii) to avoid having to make payment to Enron and the company was not obliged to close-out the ISDA Agreement.

In a client note about the case, Allens Arthur Robinson advises lenders to incorporate in their inter-creditor arrangements with hedge banks, or other relevant counterparties, provisions to restrict them from limiting the assets of the borrower available to be distributed to creditors or the cashflow available in security enforcement. However, the law firm notes that negotiating changes to existing and future ISDA Agreements may be difficult, as "counterparties will want to preserve their options".

Peter Green, capital markets partner at Morrison & Foerster, suggests that among the major lessons to learn from the Lehman bankruptcy are to keep track of posted collateral, ensure that the return of any excess is requested and consider carefully the legal framework of the jurisdictions where a counterparty has exposure. "For example, it is important to consider how collateral could become trapped," he says.

Parties are also likely to focus more on the circumstances in which collateral is required to be delivered. "Normally under the collateral arrangements, a counterparty only has to post collateral if their exposure goes beyond a threshold amount that is set at a reasonably high level, depending on the creditworthiness of the counterparty. Now, the level of the threshold amount may have to be reduced; for instance, it is likely to become more common to see provisions whereby the threshold amount will be reduced or removed if a counterparty's rating falls below a certain level," Green concludes.

CS

Operations

First-round TALF requests in, collateral expanded

US$4.7bn worth of loans was requested during the 17-19 March TALF operation, the New York Fed has announced. The breakdown of the loan requests show that US$1.9bn was requested for auto deals and US$2.8bn for credit card deals. Loans were not requested for student loan or small business loan deals.

"This is a good start for a programme that we will continue to build on in the future," comments FRBNY president William Dudley. "It is encouraging that the spreads in the areas where the programme is now focused have narrowed significantly. Our goal is to get the securitisation market working again (see also separate News Analysis)."

Subscriptions for the April funding will be accepted on 7 April and those loans will settle on 14 April. The eligible collateral for loans extended by TALF in this next phase is being expanded to include four additional categories of ABS: mortgage servicing advances; loans or leases relating to business equipment; leases of vehicle fleets; and floorplan loans.

It is hoped that accepting ABS backed by mortgage servicing advances should improve the servicers' ability to work with homeowners to prevent avoidable foreclosures. The additional new ABS categories complement the consumer and small business loan categories that were already eligible - ABS backed by auto loans (including auto floorplan loans), credit cards loans, student loans and SBA-guaranteed small business loans.

The Fed also announced its loan rates for the latest TALF auction. Fixed-rate auto and credit card loans were set at 2.733%, while floating-rate auto and credit card loans were set at 1.523%.

Private and government-guaranteed student loan floating rate notes are set at 1.5% and 1.023% respectively. Floating-rate SBA 7a loans are set at 1% and fixed-rate SBS 504 loans at 2.223%.

AC

RMBS

Fed's MBS purchase power increased

In order to support the US Federal Reserve's announcement that it will employ "all available tools" to promote economic recovery and to preserve price stability, the Federal Open Market Committee has increased the size of the Fed's balance sheet. Specifically, to provide greater support to mortgage lending and housing markets, the committee will increase the Fed's balance sheet by purchasing up to an additional US$750bn of agency MBS (bringing its total purchases of these securities to up to US$1.25trn this year) and to increase its purchases of agency debt this year by up to US$100bn (to a total of up to US$200bn).

Information received since the FOMC met in January indicates that the US economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. However, although the near-term economic outlook is weak, the committee anticipates that policy actions to stabilise financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

ABS analysts at Barclays Capital note that the results of the Fed's agency MBS programme so far have been striking: since the start of the year, mortgage spreads have tightened, financing conditions have improved and MBS dollar prices have been well supported. "Yet despite this improvement, the government has fallen somewhat short of its goals of bringing down mortgage rates," the analysts observe. "Furthermore, most of the market still had only one question for the Fed: what happens when the Fed has its fill of MBS?"

Prepayment speeds are nonetheless expected to pick up materially over the next several months, potentially to 40-50 CPR, according to the BarCap analysts. Lower mortgage rates and faster prepayments also point to a surge in MBS issuance over the next year, with gross agency supply likely to reach US$2.5trn- US$3trn over the next year if rates are sustained near current levels.

CS

SIVs

SIV asset sale scheduled

Standard Chartered's SIV, Whistlejacket, has entered into restructuring and portfolio sale agreements with Goldman Sachs. The SIV's restructuring process looks set to mirror that of the Cheyne SIV in June last year (SCI passim), which will entail GS auctioning off a portion of the vehicle's assets in order to gauge the correct market price. The remaining assets will then be sold into a new SPV established by the bank, using price levels from the auctioned assets.

Existing senior SIV investors from Whistlejacket will be invited to invest in the new structure, dubbed NewCo. The sales of the assets are expected to take place on or around 29 April, with settlement due to take place shortly thereafter.

However, Deloitte - the receivers for Whistlejacket - says it does not anticipate that cash proceeds from the sale of assets will be sufficient to allow any payment to be made to the holders of the capital notes or to any other party that is subordinate to the senior creditors in the priority of payments.

AC

Operations

Better economic paradigms

Stefan Wasilewski, ceo Contingent Capital Corporation, discusses a bridge to sustainable economic metrics

Reprise
In two previous articles (see SCI issues 118 and 125) I suggested that Alan Greenspan was not at fault for making a mistake, but that the world had moved on without informing him of fundamental changes in the manner and content of modern reporting processes - especially with regard to their use in risk assessment. I think we should now move on to someone else whose world view has changed: Jack Welch, former chairman and ceo of General Electric (USA).

The articles discussed the fact that correlations in business are dynamic, conditional and unknowable; but not unmanageable. The latter was justified by the belief that one could establish a functional control methodology (a map of sorts) to correctly identify the current state of the businesses market context and how we should respond.

It was also mooted that establishing these protocols across a business would facilitate better capital risk management and in future stabilise earnings. It did not guarantee a riskless state but shifted the focus away from short-term earnings towards business sustainability.

The paradigm shift required was explained in general terms and didn't go into how existing risk tools need to be augmented to this new approach. In this article I'd like to suggest how these new and developing concepts can be used alongside existing risk metrics.

For those with little time: don't trash the 'quants' or calculators yet
It is important and you should read further, but essentially the argument is: commonly-used statistical processes assume 'homogeneous' data and conditions to achieve meaningful results, but we know that businesses and the economy don't perform in a regular fashion. Only by creating the conditions upon which these assumptions are based can they be used reliably so that data can be provided that is timely, contextual and therefore useful.

How do we achieve it? By ensuring each enterprise can cope with market volatility, has real-time data and is functionally well structured. You do this by identifying the internal processes and mapping them to a consistent functional model.

Once in situ all the existing financial/risk tools can be used with one modification: a variable created to describe the state of a business with respect to its environment. This is because the functional approach creates the mathematical conditions needed for traditional pricing assumptions to work.

Therefore, by taking our 'map' of a well-behaved organisation, we can compare how local businesses should operate, then how they fit within the economic environment and so on until we encompass the globe. Although we set different parameters at each level at which control is exercised, we allow freedom of investment choice but guide the economy to meet our expectations. All this can be done using simple tools and benefits from modern internet communications and open-resource applications because 'the map' is the same, even though the processes may be different.

Jack Welch, 6-Sigma and current thinking
I choose Jack Welch because of an article in the Financial Times¹ ruing the focus on short-term profit and share price gains. To quote, he said: "On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy . . . Your main constituencies are your employees, your customers and your products."

We agree on one thing: 'shareholder value is a result not a strategy'. But using inappropriate methodologies to achieve your strategy will largely repeat the current problems and its beauty is in the 'eye of the beholder'. The irony for me is that I believe GE US created a lot of the impetus to innovate financial products² using many of the instruments at fault today for that (shareholder value) same reason and that his nickname, 'neutron Jack', is at odds with how he treated a 'main constituent': employees.

Another issue I have is his pioneering use of 6-Sigma as a financial markets risk-tool when its real application is in manufacturing, where it should have stayed - but even then seriously modified. In particular, I refer to the application of the Normal Distribution within 6-Sigma, and most risk metrics, on the assumption that the data is homogeneous and used without reference to the contextual economic dynamics of the business.

Some would say you can apply modern copula techniques to achieve a confident result, but their own assumptions regarding correlations are suspect. What is at issue here is not the tools but the data and how it is derived. Homogeneous data comes from consistent production processes within a stable system, which imputes the concept of time and therefore expected results.

For those that aren't familiar with it, 6-Sigma is a methodology created to track the defects in linear production processes. As Wikipedia quotes it: "6-Sigma seeks to identify and remove the causes of defects and errors in manufacturing and business processes. It uses a set of quality management methods, including statistical methods, and creates a special infrastructure of people within the organisation ('Black Belts') who are experts in these methods. Each 6-Sigma project carried out within an organisation follows a defined sequence of steps and has quantified financial targets (cost reduction or profit increase)."

The italics are mine and designed to highlight the focus on 'processes' and their financial result. My issue lies in the word 'organisation', which is never properly defined. What's more, throughout 6-sigma literature the focus on 'quality, process and management' never relates to the contextual environment of the business sell or the necessary functions required within all 'organisations'.

It uses an aspect of linear programming within a bounded space, which is great if you're living in one, but we don't. Look up; the illusion of a sky is just that. In reality our environment goes out to the stars, the most important of which is 93 million miles away and whose operation is still mainly unknown to us.

So why do we place our faith in formulas that produce erratic results at the core of our modern financial risk pricing? It's because if we didn't make the assumptions that derive them, the mathematics would be intractable and we wouldn't have the culture we see today.

Whether you talk about 'ergodic systems', the 'second law of thermodynamics' or simply 'homogeneous data', you are addressing the same concept - 'a closed space can be mathematically well-behaved' or 'short hand formulae's get good results most of the time'. The core of most economic risk pricing relates to the same assumption.

Also, as we noted in the last article (SCI issue 125), 'Time' is an essential element in finance because we assume things are going to happen in 'such and such a well-behaved way' such that our expectations are met. Credit assessment/pricing implicitly embodies this in its definition of a sustainable business when it 'rates' an entity.

Well, you can see where I'm going. We don't live in economically well-behaved boundaries and have not taken into account rapid changes in environment, with the result that the data is not 'homogeneous'. And, as our metrics are therefore wrong, there's no data to support us in finding a solution to our current problems.

Building a bridge to another paradigm
The articles' new paradigm had us building sets of 'self-similar' organisations, composed of common functions but different product processes, which took resources as input and products as output for onward use. In between we created a 'black-box' that was consistent and well formed.

These could then combine with others using the same functional map such that they created another stable entity but a different level of activity. The focus was on sustainability; a time-frame to match our expectations and/or performance; and deriving information about the state of the businesses, market or economic context, as well as the internal performance of management.

Strange; in defining this approach we create the environment that traditional metrics need in order to make their 'assumptions' of bounded and/or well-behaved spaces hold true. At the same time, we establish a better understanding of our environment as it relates to our own performance.

I used the italics again to highlight the key issues. 'Functional map' refers to a consistent set of 'functions' needed to manage the 'processes' of the organisation. The 'map' also includes the required connections to maintain internal and external communications.

In order to keep this consistency, the individual and group structures must be similar - which has ramifications for conglomerates as it demands different parameters and hence capital to be set against the risks. It also means that regulatory authorities need to be 'in the market' in order to control the market. Hence the Bank of England needs an operative arm again to monitor the flows of national debt and product creation.

Recursion revisited
By using the 'functional map' we build a consistent operational ability: a generally bounded organisation or 'system'. When several of these 'systems' find a common thread, another 'functional map' can be created to make sure that they again provide consistency.

It is this 'nested' or Russian doll-like approach we call 'recursion'. By setting different performance parameters at each level or boundary at which corrective management is needed, we can control how the whole operates.

We can therefore describe the practical aspects of recursion as follows:

Level 1: Assume we start with a bus manufacturer. Producing the buses has certain processes and we organise it properly as above. The output, buses, need local operators whose business model is different but organisationally can be the same; they buy the buses and operate them.

Level 2: The local council needs to make sure that the fares of the operators are 'fair' to the locals, which is intertwined with the economy of the area and the manufacturer.

Level 3: A bank invests in the manufacturer, operator and other businesses within the local area.

Level 4: The government needs to make sure that all local councils are regularly managed along with the capital needed to support the banks.

So how do we implement this approach? Well, we have a good functional map in a product called the Viable System Model³ and we can more than ably derive the necessary processes and communications network using two investigative processes - 'the sensitivity model' by Frederic Vester and 'syntegration' by Stafford Beer. Each compliments the other, but the latter is the forum in which the former derives the complete set of processes and business model.

It is making sure that the boundaries are clearly defined and the control parameters set appropriately that is the skill of the new organisational paradigm. The output is better: more consistent data with a clearer understanding of the real dynamics because most people are astounded at the outcomes as they fly in the face of their common assumptions of how their organisation should perform.

Next article: practical examples?
In the next article we will look at real world examples: pricing the creditworthiness of a business and the rating of a complex bank. However, we have described a framework within which we can build organisations that can adapt to market volatility and show consistency such that the 'systems' create reliable data that is transparent.

We don't have to throw out the calculators or 'quants' because, as long as we operate within the functional framework, the mathematics will become stable enough to use similar metrics. What's more, we will have another metric - one that reflects the activity of a business within its environment.

But, you say, we can't all follow the same route. That's fine; businesses emerge all the time and risk appetite varies. As long as the overall is managed in the context of the three generally accepted paradigms - ordered, complex and chaotic - we can build a model that caters for all but the truly catastrophic. But at least these will become more rare.

Footnotes

¹ 'Welch condemns share price focus', by Francesco Guerrera in New York. Published: 12 March 2009 18:13
² Some would say to mask lacklustre performance elsewhere and keep the earnings high
³ Viable System Model: Stafford Beer - John Wiley & Sons

Duo hired for distressed strategy

The latest company and people moves

Nim Sivakumaran and Sameer Dalamal are said to have joined Och Ziff's European structured credit team to enhance the firm's distressed structured products strategy. Sivakumaran joins the firm from Citi to cover RMBS and Dalamal joins from Deutsche Bank to cover CMBS. Och Ziff declined to comment on the appointments.

Manager takes on credit fund plus FI team
Liontrust Asset Management has hired the European fixed income team from Ilex Credit Fund. The team consists of five partners: Simon Thorp (cio), James Sclater (senior portfolio manager), Paul Owens (co-head of research), Quentin Peacock (co-head of research) and Gareth Roblin (chief operating officer).

The team manages the Ilex Credit Fund, which was one of the earliest European long/short credit funds when it launched in June 2000 and has £41m in assets. Liontrust International has entered into an agreement with Ilex to acquire the investment management contract for the fund for £1m in cash.

Liontrust intends to launch a number of collective investment vehicles that will adopt the investment process used by the team, including further alternative investment funds, authorised unit trusts and offshore funds. In addition, Liontrust will offer the fixed income investment process to the institutional market via segregated accounts and pooled institutional funds.

"Recruiting Simon Thorp and the team is a key part of our future strategy," says Nigel Legge, ceo of Liontrust. "We have previously stated that our objective is to broaden our product range and expand into new asset classes."

He adds: "The Ilex team meets the five tests we set when deciding whether to recruit new fund managers. These are that new fund managers will not put at risk our existing business, they can produce a documented investment process, they can be sold into both the retail and institutional markets, they have small teams and are scalable at similar margins as our existing business."

Film structured finance experts hired
Aladdin Capital has appointed Laura Fazio, Nan Logan and Jim Irvin to its newly created telecommunications, media and technology business. Fazio and the team will provide advisory and capital raising services for telecom, media and technology firms, as well as opportunistically invest junior capital across the industry sector. The team will be based in Aladdin's Stamford, Connecticut headquarters and report directly to Neal Neilinger, vice-chairman and cio of Aladdin.

Fazio joins Aladdin as md and head of the advisory and capital markets practice for the global telecom, media and technology sector. Prior to joining Aladdin, she was the global head of media and entertainment structured finance at Deutsche Bank until 2008.

Logan also joins Aladdin as md, moving over from Deutsche Bank, where she was a director of media and entertainment structured finance. At Deutsche she was responsible for originating, structuring and syndicating filmed entertainment transactions.

Irvin will join Aladdin Capital in April as a director in the global telecom, media and technology advisory and capital markets business. He joins from the London office of the entertainment industry team of JPMorgan Securities, where he most recently spearheaded the investment banking origination and execution efforts of the firm to the European marketplace.

Fund alters investment strategy
The trustees of Eaton Vance Limited Duration Income Fund have approved CMBS as a permitted investment for the fund. The fund currently invests at least 50% of its total assets in MBS and investments rated below investment grade, which include senior loans and high yield bonds. The fund is also authorised to invest in other assets, including unsecured loans, ABS, credit-linked notes, tranches of collateralised obligations, investment grade fixed income debt obligations and money market instruments, such as commercial paper.

Under normal market conditions, the fund expects to continue to maintain a dollar-weighted average portfolio credit quality of investment grade.

Derivatives 'guru' switches law firms
Quinn Emanuel Urquhart Oliver & Hedges has appointed derivatives and structured products legal expert Daniel Cunningham to the firm's New York office. Cunningham moves over from Allen & Overy, where he has been the senior partner of the New York office since 2001. He is expected to play a pivotal role in the expansion of the firm's complex financial product and bankruptcy litigation practices.

Since 1984 Cunningham has participated in the preparation by the ISDA Documentation Committee of standard documentation for derivatives transactions, including the 1987, 1992 and 2002 ISDA Master Agreements, the 1991 ISDA Definitions, the User's Guide to the 1992 Master Agreements, the 1994 Credit Support Annex (New York Law), the Credit Swap Confirmation and the 1998 FX and Currency Option Definitions. He has also participated in developing legal positions for ISDA in 35 jurisdictions worldwide.

Quinn Emanuel's managing partner John Quinn says: "Daniel's addition to our firm does not signal that we are abandoning our litigation-only model. A very significant part of our practice is litigation involving complex derivatives, swaps and other structured financial products."

Financial restructuring lawyer re-hired
Stroock & Stroock & Lavan has re-hired Andrew DeNatale for its financial restructuring practice group as partner and head of the special situations lending group. DeNatale was the former co-head of White & Case's financial restructuring & insolvency group.

DeNatale worked at Stroock from 1980 until 1991 and was promoted to partner in 1984. As head of the special situations lending group, DeNatale will focus on restructuring on behalf of financial institutions. His capital market experience includes advising on a variety of matters, including major Chapter 11 proceedings, multinational bankruptcy cases and the structure and restructuring of corporate and financial transactions to eliminate or reduce insolvency-related or lender liability risks.

DeNatale's participation in structuring and restructuring corporate and financial transactions includes counselling on lender liability, equitable subordination and derivative transactions.

Loan outsourcing solution launched
Cortland Capital Market Services and ClearStructure Financial Technology (formerly Atlantic Information Services) have teamed up to provide a joint loan administration solution to the syndicated bank loan market. The full bank loan outsourcing solution integrates Cortland's loan administration services with ClearStructure's web-based portfolio management platform, Sentry.

Users of the service will have their bank loan data updated daily by Cortland and fed directly into Sentry. For those users not in need of a full loan management platform, Cortland will provide access to CorPro, a web-based data portal powered by Cortland and Sentry technology. CorPro will allow Cortland clients to submit and view pending trades, run hypothetical trade scenarios and access information, such as reconciled facility-level data, detailed reports and agent notices via the web.

"By streamlining process and technology for trade settlement, loan administration and loan agency, Cortland provides a cost-effective full outsourcing solution for the bank loan market," says Matthew Biver, Cortland's director of analytics and data management. "We eliminate the manual nature of administering bank loans and other complex structures, allowing asset managers to focus on picking credits and other core business functions."

Permacap reports
Permacap Carador has reported that, as at the close of business on 28 February 2009, the unaudited net asset values per share were €0.4769 (a monthly performance of -0.98%) and US$0.6090 (-1.01%). The month's calculations include an estimated €1,924,362.77 of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0134 or US$0.0170 per share.

AC & CS

Further significant risk reduction implied

A round up of this week's structured credit news

Analysts at Credit Derivatives Research note that the latest DTCC data, from the week ending 13 March, saw the largest net risk reduction (protection buying) since their records began. "A huge systemic risk reduction trend continues, with US$249.4bn added this week - dwarfing the US$75bn per week average of the last five weeks," the analysts say.

Gross CDS notionals rose by only 1.2% (US$336bn) to US$27.5trn, with single names seeing their largest rise in five weeks (1.71%) to US$14.9trn, while indices remained unchanged at around US$9.2trn and tranches rose by 2.4% to US$3.5trn (the largest rise this year). The CDR analysts suggest that these trends appear to signal that credit has caught up with equity market fears. Furthermore, some of the positive tones coming out of the bond market might indicate that basis trades are being placed again, which would further help compress the basis as ICE clearing begins.

Somewhat unusually ABX and CMBX indices were among the most active during the week. All the ABX indices saw net reduction in contracts, with lower quality older vintages experiencing net notional decreases (the CDR analysts suspect that covering of shorts ahead of TALF2.0 drove this activity). CMBX also saw a similar pattern with what appears to be major notional reduction across all tranches.

Fair value accounting proposals revealed
The FASB has issued two proposed staff positions (FSPs) intended to provide additional application guidance regarding fair value measurements and impairments of securities. Proposed FSP FAS 157-e, 'Determining Whether a Market Is Not Active and a Transaction Is Not Distressed', provides guidelines for making fair value measurements more consistent with the principles presented in FASB Statement No. 157, 'Fair Value Measurements'.

Proposed FSP FAS 115-a, FAS 124-a and EITF 99-20-b, 'Recognition and Presentation of Other-Than-Temporary Impairments', provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities. These statements are intended to provide greater clarity to investors about the credit and non-credit component of an OTTI event and to more effectively communicate when an OTTI event has occurred. As proposed, the FSP would apply to both debt and equity securities.

The proposed FSP requires separate display of losses related to credit deterioration and losses related to other market factors on the income statement. Market-related losses would be recorded in other comprehensive income, if it is unlikely that the investor will have to sell the security prior to recovery.

Beyond these near-term proposed improvements, the FASB has a joint project with the IASB aimed at more broadly revamping and converging their respective standards on accounting for financial instruments.

Index rolls completed/scheduled ...
The Markit CDX.NA.IG and HiVol indices rolled into series 12 on 20 March, while the EM and EM Diversified indices rolled into series 11 and 9 respectively. CDX.NA.HY will roll into series 12 on 27 March, followed by the MCDX index on 3 April 3 and LCDX on 15 April (both into series 12). Dealers voted against rolling CDX.NA.XO into a new series due to a lack of liquidity.

The iTraxx LevX Senior index also rolled into its fourth series on 20 March. Twenty-one constituents have been removed from the index and none were added. Four constituents had already been removed from the index due to credit events and cancellations following a refinancing.

In addition, the iTraxx Asia ex-Japan and Australia indices rolled into their eleventh series on 20 March, while iTraxx Japan rolled into its eleventh series on 23 March. Ten constituents were replaced in the iTraxx Japan Main index and two in the iTraxx Asia ex-Japan IG.

Meanwhile, the iTraxx Europe indices rolled into their eleventh series on 20 March 2009. Based on liquidity polls, the following changes have been made to the indices:

• Eleven constituents replaced in the iTraxx Europe Main.
• Fourteen constituents removed and nine added to the iTraxx Europe Crossover.
• Eighteen constituents replaced in the iTraxx Europe HiVol.

Series 11 of the iTraxx Europe Crossover will comprise 45 entities instead of 50 to ensure only the most liquid eligible entities are included in the index. The constituents of the iTraxx Europe Main will now 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.

The maximum cut-off level for inclusion in the iTraxx Europe Crossover has also been changed from 25% upfront plus 500bp running spreads to 50% upfront plus 500bp running spreads to reflect the spread widening across the market.

As expected, the new indices traded much tighter than the older ones (SCI passim), largely due to better quality portfolios.

... while CMBX trading convention is changed
The standard trading convention for Markit CMBX indices will change to price from spread, effective from 20 April 2009. The change will apply to all Markit CMBX indices of every rating. Dealers voted to change the standard trading convention in order to increase price transparency by making the upfront value of index contracts explicit.

Three credit events announced, another to follow?
ISDA is to launch CDS auction protocols to facilitate the settlement of credit derivatives trades referencing Chemtura Corporation, the Rouse Company and LyondellBasell Industries AF SCA. Meanwhile, Abitibi is likely to become the next name to trigger a credit event, following its failure to pay down a US$347m short-term facility.

Chemtura Corporation is a global manufacturer and marketer of specialty chemicals. The company announced on 18 March that it and 26 of its US affiliates have filed voluntary petitions for relief under Chapter 11 of the US Bankruptcy Code in the US Bankruptcy Court for the Southern District of New York to facilitate financial restructuring.

Rouse is a subsidiary of General Growth Properties, the Chicago-based real estate company. Rouse was reported to have failed to pay more than US$2bn in debt on March 16.

The Netherlands-based petrochemicals producer LyondellBasell Industries was also reported to have failed to pay interest on US$679m of bonds maturing in 2015. The company missed a payment due on 15 February and a 30-day grace period expired on 19 March.

ISDA will publish the protocols and auction terms in the coming weeks. The LyondellBasell auction is scheduled for 16 April.

CCP reports initial CDS processing volumes
The ICE Trust has processed over US$21bn in CDS index contracts since it began centrally clearing the trades two weeks ago. The firm has reported that the aggregate exposure of such instruments has been compressed to US$4bn.

Meanwhile, ICE subsidiary T-Zero has launched a new re-couponing service ahead of the single name coupon standardisation that comes into effect on 8 April. On this date, the CDS market will move to a new single name standard North American corporate (SNAC) 100bp and 500bp coupon CDS contract in order to help prepare the market for clearing of single name trades in a manner equivalent to the way CDS index contracts are now being centrally cleared.

One of several firms offering such a service, T-Zero's portfolio re-couponing initiative will allow both dealers and buy-side firms to efficiently transition existing non-standard single name CDS positions to the new SNAC convention.

CDS data portal launched
Markit has launched a CDS data and information portal designed to increase transparency and provide a broader audience with a tool to monitor the market. The new data portal will make a wide range of Markit's independent CDS data sets, including the CDX and iTraxx indices, publicly available.

In addition, the last quote received by Markit before New York close of trading for approximately 450 of the most liquid CDS contracts and the biggest daily single name CDS movers for North America, Europe and Asia will be made available. Daily Markit/ICE Trust CDS settlement prices for the most liquid CDX index contracts listed for clearing by ICE Trust will also be included.

Furthermore, in support of the industry's migration to a standardised CDS contract and quoting convention, Markit has published a free online calculator that converts CDS spreads into the new upfront quoting convention.

Two-notch downgrades likely for SME deals ...
The probability of default (PD) assumption for an ABS transaction backed by loans to SMEs is one of the most important asset parameters for rating such transactions, says Moody's in a new rating methodology report. Together with the recovery rate and correlation framework assumptions, the PD assumption is the main driver of risk and related credit enhancement in SME loan securitisations, the agency says.

In the report, Moody's explains the sources of information it uses to derive this vital assumption and the impact this can have on the rating. In particular, Moody's formally introduces the concept of a top-down approach to estimate PD assumptions for granular SME portfolios in EMEA.

As a result of this refined approach, the agency expects to take some rating actions in the near future that will affect around 35-40 granular EMEA SME transactions. In particular, transactions rated before the end of 2007 that have not yet built material additional credit enhancement are likely to be more affected throughout the whole capital structure. Moody's anticipates that these transactions could experience a one- to two-notch rating migration on triple-A.

"To determine the PD for an ABS SME portfolio, Moody's typically uses a combination of pool-specific information, such as historical performance data, public ratings, internal scoring/rating systems, Moody's credit estimates and/or Moody's KMV RiskCalc outputs," says Monica Curti, a Moody's vp, senior analyst and co-author of the report. "This is combined with more generic sources of information, such as performance monitoring data on previous deals and macroeconomic data to determine the default assumption for granular SME portfolios."

Moody's notes in the report that, to date, the two main sources of information have been historical data and internal scoring systems, especially in the two major SME securitisation markets (Spain and Germany). However, the available historical data usually only covers a short period (less than six years), which does not enable the rating agency to make an assessment of the average creditworthiness of the SME portfolio across the business cycle.

"Moody's will complement any pool-specific information with a top-down approach for the rating analysis of granular SME portfolios," explains Luis Mozos, a Moody's avp, analyst and co-author of the report. In this top-down approach, a country-specific base PD assumption is then adjusted for the securitised portfolio quality and macro-economic factors (cycle adjustments).

"Moody's first introduced this top-down approach to rate granular SME-backed transactions in EMEA in the second half of 2007 and since then has been further refining the approach. However, borrower-specific information, such as Moody's credit estimates, will still be needed when the top borrowers make up a significant portion of the securitised pool," Mozos adds.

Moody's also notes that the European SME loan sector currently has a negative outlook and has shown signs of increasing weakness in terms of credit performance. The sector is further stressed by the anticipated limited refinancing opportunities for non-financial corporate issuers in the region rated Baa and below over the next six to 12 months. Some granular EMEA SME transactions are already under review due to performance-related concerns.

... with €22.6bn worth of deals impacted
Moody's has placed €22.6bn of European SME CLOs on downgrade review, following the agency's new approach to rating SME CLOs (see above). The ratings of 163 classes of notes in 38 transactions have been impacted, including triple-A tranches. Those deals affected by the downgrade review include numerous Spanish deals, COSMO Finance transactions, Geldilux transactions, Clock Finance, Chaves SME CLO 1, BEL SME 2006-1, ROOF CEE 2006-1, SMART 2006-1, SMILE transactions, Goodwood Gold CLO and Ascot Black CLO.

CDS margining pilot proposed
The Financial Industry Regulatory Authority (FINRA) has proposed a pilot programme for the margining of CDS by FINRA-registered firms that clear CDS transactions on the Chicago Mercantile Exchange, other central counterparty platforms or outside of such platforms. The initiative is detailed in a proposal FINRA has filed with the SEC, with a request for accelerated approval. The programme would expire on 25 September 2009 - the same day that the SEC's temporary rules providing for the establishment of central counterparties for CDS transactions expire.

It is expected that, with the creation of CDS central counterparties, an increasing volume of CDS transactions may be handled through broker-dealers. The FINRA proposal recognises this possible development and seeks comment on whether the potential risk to the broker-dealer channel makes sense as part of an endeavor to create greater systemic stability. The rule proposal also requires that a firm notify FINRA of participation in the CDS central counterparty trading prior to the commencement of any such activity.

CDPC's ratings withdrawn
Moody's has withdrawn the provisional ratings of Lutece - a CDPC incorporated in the Netherlands. According to the rating agency, the vehicle is not intended to be launched in the foreseeable future due to prevailing adverse market conditions.

Barclays issues US$16bn in CLO tap
Moody's has assigned a triple-A rating to US$16.5bn additional notes issued by Newfoundland CLO 1. The deal, which first issued notes in November last year, is a cash CLO related to a US$39.1bn par value portfolio of primarily senior secured and unsecured corporate loans denominated in multiple currencies, managed and originated by Barclays Bank.

Moody's notes that following the issuance of the additional notes, some terms of the transaction have also been amended. These changes essentially broaden the eligibility criteria that assets have to meet to be included in the portfolio; modify the portfolio guidelines; and adjust the subordination level by the issuance of subordinated notes. Despite the changes, the ratings on the previous notes issued by Newfoundland have been affirmed.

39% of Fitch's SF deals downgraded in 2008
Fitch reports that downgrades affected 39% of its global structured finance ratings in 2008, with the vast majority (96%) of the year's downgrades concentrated in RMBS and CDOs. While 87.2% of structured finance bonds rated triple-A by Fitch at the beginning of 2008 remained triple-A at year-end, 12.8% of them were downgraded over the course of the year, with 5.2% of triple-A bonds downgraded to a lower investment grade rating and 7.6% downgraded to below investment grade.

Vintage played an important role in the year's negative rating drift: 82% of the year's downgrades consisted of bonds brought to market from 2005 to 2007.

The impairment rate on Fitch-rated global structured finance bonds also rose in 2008 to 16.8% from 2.6% in 2007, but the rate - consisting of bonds in default or near default - varied by broad sector and rating category. The triple-A impairment rate was 0.97%. Across all investment grade rated structured bonds, the impairment rate was 10.9% in 2008, and 38.2% across speculative grade bonds.

Given the year's economic and funding difficulties, structured finance upgrades fell 64% in 2008 and affected less than 2% of ratings. While scarce across RMBS and CDOs, upgrades remained meaningful for outstanding ABS (8%) and CMBS (5%) ratings. ABS and CMBS, despite beginning to show strain in 2008, a consequence of the recessions forming in the US and Europe, recorded relatively high levels of rating stability, Fitch reports.

Rating activity outside of the US, while also under pressure, was more balanced than in the US. Across European structured finance, downgrades affected 16% of ratings and upgrades affected 3%.

Moody's continues CLO downgrades
Moody's has downgraded 654 notes from 198 US CLOs issued between 2001 and 2008, as well as 188 notes from 64 US cashflow CLOs primarily backed by SME collateral. At the same time, it has downgraded 183 notes from 114 European cashflow CLOs issued between 1999 and 2004.

According to Moody's, the rating actions taken on the notes are a result of applying the revised assumptions for rating CLOs announced earlier this month. These revised assumptions include a 30% stress to the underlying portfolio default probability, the modified treatment of ratings on review for possible downgrade or with a negative outlook, and a change in the calculation of the diversity score. The actions also reflect a general consideration of the credit deterioration in the underlying portfolios.

The ratings of all affected CLO tranches remain on review for possible downgrade.

AIG-related CDOs hit
Moody's has downgraded its ratings of notes issued by certain CDOs that have exposure to AIG FP and which additionally hold collateral that consists of Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. It has downgraded the ratings of another 146 notes, and confirmed the ratings of four, issued by 38 CDO transactions that also consist of significant exposure to these asset classes. The agency explains that the rating actions reflect certain updates and projections, as well as recent rating actions on underlying assets.

Portfolio optimisation analysed
MSCI Barra has released a report highlighting the risks of using portfolio optimisation tools based on one set of factors and alpha models based on another, overlapping set of factors. Discrepancies between risk and alpha factors may create unintended biases, according to the report, leading to the idea that it is better to use a risk model that is more aligned with the alpha factors.

Indeed, the research shows that better aligning risk factors with alpha factors may improve the information ratio of optimised portfolios. The authors propose four ways of modifying a risk model to reduce misalignment.

Another way to mitigate the problems arising from misaligned risk and alpha factors is to modify the optimisation process itself. In particular, the portion of the alpha that is not related to the risk factors can be 'penalised' to counteract the optimiser's tendency to overemphasise this portion, the report says.

Sub-IG SF CDOs downgraded
Fitch has downgraded 78 tranches (69 public ratings and nine private ratings) and affirmed 18 tranches (all public) from 38 structured finance CDOs in Europe. In addition, the agency has assigned recovery ratings to the notes.

All of the transactions affected by the rating action were previously downgraded to single-B and below during 2008, following actual and expected deterioration in portfolio credit quality, primarily related to US Alt-A and sub-prime RMBS. The actions reflect the continued deterioration in portfolio credit quality, particularly in relation to defaulted assets and assets rated triple-C or below.

Fitch analysed the current available credit enhancement for each tranche in relation to asset buckets rated single-C, double-C and triple-C. In most cases the existing single-C buckets would exceed the available credit enhancement of the notes and hence have resulted in the majority of actions being downgrades to this rating category. In most cases Fitch has also assigned recovery ratings of RR6, reflecting the expectation that the tranches may continue to receive interest payments for a limited time before credit events in the portfolios are called and settled, at which time it is likely that as most tranches are comparatively thin the balance of the notes would be completely written down.

Favourable seasonable effect for remits
In the upcoming March ABX remits, favourable seasonal effects should keep the growth of delinquencies slower than last month, analyst at Barclays Capital note. For example, they expect serious delinquencies to increase by 50bp-70bp for the 06 series and by 90bp-190bp for the 07 series - a smaller rise than last month.

Given one fewer business day in March versus February, CDRs are likely to remain flat or slightly decline for the 06 series with a shrinking REO bucket, and post a moderate rise of 50bp-70bp for the 07 series with a slightly increased REO bucket this month. Without a sufficient agency-eligible population to lift voluntary prepayment speeds, CRR should continue to decline across the four ABX indices, the analysts add. Series 07-2 is coming off the peak of its first rate reset and is expected to post the largest decrease in voluntary prepayments.

Nationwide REO inventories were largely flat at 838,500 homes in January. BarCap expects a 1%-2% rise in February, however.

European CLO performance reviewed
S&P has published its 2008 review on European CLOs entitled 'Declining Corporate Credit Quality Raises Questions About Future CLO Performance'. The report says, that although European CLOs exhibited relatively stable ratings in 2008, some troubling trends emerged during the year as global financial and economic disruptions began affecting the creditworthiness of an increasing number of speculative-grade European firms.

"The credit quality of speculative-grade European firms as a whole took a decidedly negative turn in 2008 as represented by a rising number of downgrades and defaults," the agency says. "We expect that the negative trend of rating downgrades, negative outlook changes and defaults among speculative-grade European firms witnessed in 2008 will continue and intensify in 2009, with funding to remain tight, expensive and largely inaccessible for speculative-grade firms. This will likely affect our analysis of the credit quality of securitised loan portfolios and hence place downward pressure on the ratings on European CLOs."

However, the strength of collateral packages securing loans to such firms will dictate in part the real effect of any rise in defaults, S&P adds. The rising default environment and developments in loan features, structures and participants over the past few years may place downward pressure on post default recovery rates and, in particular, may deviate from the expected recovery rate levels assumed in our credit analysis of CLOs.

As of 31 December 2008, triple-C rated assets represented between 0% and 12.57% of the portfolios in S&P-rated European CLOs, averaging 4.58%. The rising level of such exposure in European CLO portfolios may result in an increasing number of transactions triggering cashflow diversion mechanisms and events of default, the agency warns.

In 2008, issuance of European CLOs was characterised by fewer but larger transactions. While the overall volume of issuance we rated was 24% lower than for 2007, the number of transactions fell by 57%. Total European CLO issuance that S&P rated in 2008 was €26.8bn (from 31 transactions) compared with €35.6bn (from 72 transactions) in 2007.

Traditional arbitrage CLO issuance ground to a halt in 2007 and this trend continued into 2008 as rising CLO funding costs outpaced the slower increase in primary loan spreads and a shut-down of the speculative grade loan issuance market. However, European CLO issuance did not stop entirely. A new breed of European 'financing' or 'structure-to-repo' transaction, designed to finance or refinance existing loan portfolios, dominated CLO issuance.

SROC results in for Asia ex-Japan ...
S&P has lowered 38 ratings on 37 Asia-Pacific (excluding Japan) synthetic CDOs. Fifteen ratings on these CDOs remain on credit watch with negative implications, while 23 ratings were removed from credit watch negative. In addition, the ratings on three other CDOs were affirmed and taken off credit watch negative. The downgrades reflect the increased credit risk of underlying portfolios in the respective transactions.

... and Europe
S&P has taken credit rating actions on 17 European synthetic CDO tranches following recent rating changes on the underlying collateral in those deals. Specifically, the agency: removed from credit watch developing the ratings on two tranches; removed from credit watch negative the rating on one tranche; lowered the ratings on 13 tranches; and withdrew the rating on one tranche.

Jumbo RMBS loss projections revised
Moody's has revised its loss projections for RMBS backed by prime jumbo mortgages issued in the US from 2005-2008. On average, the agency is now projecting cumulative losses of around 1.7% for 2005 securitisations, 3.55% for 2006 securitisations, 5.05% for 2007 securitisations and 6.20% for 2008 securitisations. Consequently, it has placed 4,988 tranches of jumbo RMBS with an original balance of US$240.7bn and current outstanding balance of US$173.3bn on review for possible downgrade.

In most cases, subordinate securities from 2006, 2007 and 2008 transactions are expected to be completely written down. Moody's is likely to downgrade the ratings of these securities to Ca or C.

GSO brings CLO
Ratings have been assigned to the US$240m Jackson Square CLO, a deal backed by US dollar-denominated senior secured loans to corporate borrowers. The collateral manager is GSO Debt Funds Management.

The deal's structure comprises US$187m of triple-A rated Class As and an unrated tranche of US$51.6m. The deal is rated by S&P.

Portuguese RMBS model updated
Fitch is in the process of updating its Portuguese residential mortgage default model criteria, which is used for analysing credit risk on Portuguese RMBS and covered bonds secured on Portuguese residential mortgage loans. As part of this criteria update, the agency is reviewing its default probability and market value decline (MVD) assumptions for Portuguese residential mortgage loans and properties. The review will most likely result in higher default and MVD assumptions across all rating levels.

Fitch says the updated criteria are likely to lead to a review of the outstanding ratings of Portuguese RMBS transactions, although the extent of any potential rating action is uncertain at present. However, the increase in default probabilities and MVDs could result in negative rating migration especially for less seasoned transactions where credit enhancement has not yet built up.

'Big bang' compliancy for QuoteVision
CMA has implemented the necessary updates and upgrades to its QuoteVision, DataVision and analytics product sets to support the new standardised 100/500 CDS contracts for North American single name CDS, which are scheduled to launch on 8 April.

Jav Bose, head of product development at CMA, says: "The upcoming changes to quoting conventions for single name CDS are required for smooth settlement and position netting in the CDS market. The adaptations we have made will make it easier for clients to manage the new conventions and pricing conversions, and minimise the time from price discovery to taking trading and risk management decisions."

Kamakura updates risk factors
Kamakura Corporation has completed a major upgrade of its Kamakura Risk Information Services that links 40 key macro-economic risk factors to the default probabilities of more than 20,000 public firms in 30 countries. The KRIS upgrade shows that home price-related risk factors represent the five most significant risk factors of the 40 factors in the study.

Real growth in gross domestic product and the US unemployment rate, which are two of the three macro factors mandated by bank regulators for stress testing at the 19 largest US banks, rank only 14th and 27th on the list of the 40 most significant risk factors. Kamakura reports that interest rate risk, until recently the primary risk focus of US financial institutions, ranked only 18th on the list of the top 40 drivers of corporate default risk globally. Kamakura's KRIS default probability clients can access these risk factors and related coefficients via the KRIS credit portfolio management service, KRIS-cdo.

"This upgrade of KRIS allows the users of KRIS and Kamakura Risk Manager to do the kind of 'credit risk CAT scan' that is necessary to determine the true driving factors of counterparty credit risk across the full range of counterparties," says Kamakura's president and coo Warren Sherman. "This tremendously important risk factor capability in KRIS provides completely transparent visibility of how pervasive home price risk and other risk factors are in the corporate portfolios of major financial institutions, investment management firms and corporations. Without knowing these links, it's impossible to accurately perform government-mandated stress tests of macro factors, and it's impossible to accurately simulate loss distributions and timing in a diversified portfolio."

CSOs impacted
Moody's has downgraded its ratings of 15 notes issued by eight CDOs referencing a portfolio of corporate entities. The agency says that 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 corporate synthetic CDOs; and (ii) the deterioration in the credit quality of the transactions' reference portfolios.

Improved liquidity for US CDS ...
Fitch Solutions' latest global liquidity scores commentary shows that liquidity in the US market for CDS has continued to improve since the spate of poor economic data announced at the beginning of March. In relative terms, the US market has become significantly more liquid than the European market over the last few weeks, Fitch says. The Americas index closed at 9.78 on 20 March with Europe closing at 10.18.

Meanwhile, Latin America continues to dominate liquidity in the sovereign CDS market, with Mexico being the most liquid name due to its exposure to the worsening US economy. General Electric Capital Corporation continues to hold top spot in the Americas, as the market remains concerned about the health of the US financial system, with Bank of America Corporation and Citigroup also in the top five. And Sberbank has entered the top five in Europe for the first time against the backdrop of falling commodity prices impacting the broader Russian economy in combination with the general dislocation of the global capital market.

The domination of South Korean banks in the top five Asia-Pacific liquidity scores list has been broken by the entry of Samsung Electronics Co and Hutchison Whampoa Ltd. Samsung's export markets have been severely disrupted by the ongoing economic slowdown across the globe.

... while sovereign CDS analysed
CMA's global sovereign credit risk report for Q109 highlights that the issuers of the riskiest sovereign debt in the world - Ukraine, Argentina, Venezuela, Kazakhstan and Latvia - are predominantly emerging economies with a strong dependency on a small number of industries, particularly natural resources and petro-chemicals. Pakistan and Ecuador are no longer listed in the riskiest sovereign debtors due to illiquidity in their CDS, but it is reasonable to expect that the default risk for both nations continues to be high, CMA says. Russia and Romania, which previously ranked among the riskiest sovereign debt issuers, have improved their relative situation this quarter and have moved out of the top ten.

The issuers of the safest sovereign debt in the world - Norway, Finland, Germany, France and the US - are all highly evolved, well-diversified capitalist economies, with stable, democratic governments and a strong rule of law. All of these sovereigns have seen a significant percentage increase (in some cases to record levels) in the cost of insuring their debt this quarter, but this has been consistent with all sovereign CDS that CMA covers.

A regional focus on the US and the UK shows that the 10-year point is more frequently quoted than the five-year for both nations. Price drivers going forwards for these two sovereigns include: further nationalisation/rescue packages for financial institutions or transfer of risk from the private to the public sector; effects of economic stimulus packages; interest rate levels; and engagement in 'quantitative easing'.

Grid computing for CDO reporting tool
Management and reporting tools provider CDO Software has announced that its CDO Tools suite is now grid-enabled. The move is designed to allow portfolio managers and investors to see the immediate impact of changes to market data or news and act decisively.

"With the introduction of CDO Grid to our CDO Tools product suite, you can now run agency models and analytics on multiple deals in a fraction of the time it would have previously taken," says Brett Paton, cto and co-founder of CDO Software.

Grid computing is a form of parallel computing that utilises the processing power of network-connected computers in order to solve problems that would otherwise be impossible or impractical with a single computer. Grid computing is used to solve computationally intensive calculations that can often be divided into smaller tasks.

As Paton explains: "Processes can be simultaneously executed across multiple processors connected via a network to obtain much faster results. Given the current market conditions where many firms are looking to reduce costs, it's crucial to maximise the computation power of parallel processing."

Stable outlook for Korean RMBS
Fitch says that the ratings of Korean RMBS transactions are more sensitive to market value decline (MVD) assumptions compared to other parameters, such as default probability and foreclosure period. In its Korean RMBS rating model, the agency assumes that recoveries on defaulted mortgage loans can be obtained when the underlying collateral is auctioned in the residential property market, given a stressed foreclosure period of 18 months. MVD, which governs the property value decline of a loan's underlying collateral, is therefore the key factor to assess the recovery value of a defaulted mortgage loan and, as a result, the credit enhancement and rating for a Korean RMBS transaction.

The MVD assumptions applied in the Fitch model are derived by the historical property price trends and their volatilities for different property types in different regions in Korea. Typically, regions that experience historically high property price volatilities and periods of severe property value decline would be subject to higher MVD assumptions. Properties with limited demand in the secondary market would also be subject to higher MVD assumptions, the agency notes.

Fitch has observed declining housing prices and increasing delinquencies due to the softening property market and economy, as well as rising unemployment in Korea. Although the aforementioned parameter trends are expected to continue in 2009, the agency believes these trends will stay within its expectations. Consequently, the ratings of these transactions will remain stable in 2009.

CS & AC

Trading

Trading ideas: black out

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

In addition to the obvious retailers, Black & Decker finds itself at the epicenter of a massive pullback in consumer spending. As the savings rate of the average American plummeted towards zero over the past twenty years, the recent turmoil has seen consumers begin to save to pay down debt rather than spend on discretionary items. Black & Decker's drop in fourth quarter revenues and margins reflect this and we do not believe the end is near whatsoever. We expect its credit spread will nearly double in the coming year and recommend buying protection on it.

Black & Decker's revenues severely contracted in the fourth quarter of last year across all of its reporting divisions. In addition to falling sales, operating margins have also been squeezed (Exhibit 1). The combination of declining sales and margins is disastrous for the bottom line.

Exhibit 1

The recent results even caught management by surprise. Black & Decker (BDK)'s ceo said the following in the latest earnings announcement: "The global macroeconomic conditions affecting our end markets in the fourth quarter were significantly worse than expected."

The equity markets punished BDK severely for the results and future profit expectations. BDK's stock was down over 50% two weeks ago from its early January 2009 levels. Its total debt to market cap doubled to 1.2 times over this period (Exhibit 2).

Exhibit 2

We take this evaporation of its market cap as a good sign of future credit deterioration. Though the company will likely not endure any liquidity crisis as it maintains US$935m of available credit on its revolver and US$278m in cash, we do not believe 240bp accurately reflects BDK's credit risk.

We see a 'fair spread' of 460bp for BDK based upon our quantitative credit model, due to its equity implied factors, margins, leverage 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 trading close to fair value throughout all of 2008, B&D's expected spread exploded in December and into the new year; however, it's actual CDS spread remained range bound between 200bp and 300bp (Exhibit 3). We believe that eventually the continued pullback in consumer spending will be fully reflected in BDK's credit spread.

Exhibit 3

Buy US$10m notional Black & Decker Corp 5 Year CDS protection at 240bp.

For more information and regular updates on this trade idea go to: http://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).