Contents

Investors

Structural realignment

Credit hedge funds progress with meeting investor requirements

Credit hedge funds have made significant progress in better aligning themselves with investor needs, following the liquidity issues the industry experienced in December. However, while institutional investors appear to be committed to the sector, demand from high net-worth and retail investors is less certain.

"There is increasing awareness of the need to deal with the possibility of sudden withdrawals of liquidity, as occurred at the end of last year," says Stephen Siderow, president of BlueMountain Capital Management. "For example, how can fees be based on mark-to-market when bid/offer spreads gap out in illiquid markets?"

He adds: "The industry has recognised more broadly that there are many ways of structuring funds to creatively match the liquidity expectations of investors with the liquidity of the underlying assets."

Indeed, the liquidity issues experienced by hedge funds in December underscored the need for vehicles to provide investors with access to their cash, without becoming gated or punishing remaining investors in the fund. BlueMountain, for instance, has reacted by committing to segregate and then liquidate a representative portion of its loan fund above a certain threshold to redeeming investors at the quarterly redemption date. The threshold depends on the size of the fund, but is typically 5%-10% of total assets - the idea being that the redeeming amount has to be large enough to make the creation of a representative portfolio practicable.

"The mechanism provides liquidity on regular dates and insulates the remaining investors in the fund from any potential costs associated with the sale of assets," explains Siderow. "Usually, remaining investors' NAV is impacted by asset sales (because of the NAV hit from paying the bid/offer spread), while redeeming investors receive 100%. The aim of our new redemption feature is to make redeeming investors bear the cost of accessing liquidity, albeit this will usually only be in the order of one or two points." If investors want liquidity but can't wait until there are enough redeemers to reach the threshold, they have the option to redeem with a 4% penalty.

The BlueMountain loan fund has a two-year hard lock, with quarterly redemptions thereafter, reflecting what the manager believes is an appropriate timeframe in terms of the opportunity in the underlying assets. Additionally, fees are awarded on a cash-out basis and not on an annual mark-to-market basis.

With good credit selection, BlueMountain believes that the fund will be able to generate a 10%-15% annualised return over this period. Manager and investor incentives are aligned to wait until the positions can be sold in better market conditions and the cash returned to investors with minimal transaction costs.

Historically, hedge funds were expected to have a 'standard' structure, which had solidified around what was appropriate for equities. But hedge fund structures ultimately provide the freedom to invest across many different asset classes and strategies, so vehicles have to reflect this reality, according to Siderow.

One example of this move is the recent growth in separate accounts. Such vehicles have obvious advantages in terms of the ability to customise strategies and liquidity/fee structures. However, the downside is that scale is important - not only to make it worthwhile for a manager, but also from an investor's perspective with regards to achieving reasonable prime brokerage and leverage facilities and looks from dealers on attractive trade opportunities.

"Certainly, there is greater openness about the need to balance a variety of investor needs. Such evolution is positive for the development of the industry because it brings transparency," Siderow observes.

In a report entitled 'The Hedge Fund of Tomorrow: Building an Enduring Firm', Casey Quirk and Bank of New York Mellon note that the hedge fund industry is facing a transformational crisis, which necessitates that managers address key shortcomings in their business and operating models. Moreover, client business needs must be served across four functional areas: management, operations, distribution and investments.

"The hedge fund industry's recovery and future prosperity depends on correcting the poor long-term alignment that exists between investors, firms and investment teams," the report explains. "Future alignment structures will match investor liquidity needs, portfolio liquidity, investment horizon, performance measurement and payout periods."

As part of this, fee models are expected to evolve to ensure better, more stable revenues for managers. Performance fees will vary by strategy, firm and liquidity terms, and will incorporate rolling periods and deferrals.

The report confirms a growing recognition that hedge funds represent an investment framework applicable across all traditional asset classes and investment programmes. As such, investors are likely to carve their previously amorphous hedge fund allocation into three distinct categories: market directional liquid, classic hedge liquid and illiquid. Casey Quirk and BONYM predict that, regardless of capital market returns, classic hedge strategies will experience the most stable demand.

Additionally, four viable hedge fund business models are outlined in the report. Of these, the multi-capability platform is expected to see the greatest growth in share.

Overall, the report forecasts that hedge fund assets will reach almost US$2.6trn by the end of 2013, after reaching their low point in 2009. It says that institutions are committed to hedge fund investing, having accounted for less than 17% of net redemptions during 2008 and 2009. North American institutions are likely to be the greatest source of institutional net flows into hedge funds between now and 2013.

In contrast, high net-worth and retail investors accounted for more than 80% of redemptions for 2008 and 2009. Global high net-worth investors' commitment to hedge funds will depend on capital market conditions and hedge fund returns during the next several years, the report concludes.

CS

LCDS

New strategy

Latest LCDX roll to provide viable CLO hedging tool?

The Markit LCDX rolled into series 12 last week with a number of changes in place that are expected to increase liquidity and transparency (see last week's issue). Moreover, it has been suggested that the revised index will offer a viable new hedging strategy for CLOs.

The capital structure of LCDX Series 12 has been retranched into four tranches: 0%-8%, 8%-15%, 15%-30% and 30%-100%. This replaces the previous attachment points of 0%-5%, 5%-8%, 8%-12%, 12%-15% and 15%-100%. According to structured credit strategist Dominique Toublan at JPMorgan, the new attachment points are a better match for typical CLO attachment points of 0%-9%, 7%-12%, 12%-17%, 17%-27% and 27%-100%.

"A 15%-30% and a 30%-100% tranche should be a better match for typical pre-crisis CLOs largely because the subordination difference is minimised and, as such, allows for a more valuable triple-A CLO hedge than before," he says.

However, the LCDX.12 is still not seen as a perfect hedging solution for the asset class due to the number of structural differences between CLOs and LCDX tranches. These include composition differences, cashflow differences and event-of-default sensitivities. Current market conditions reduce the significance of some of these differences, however.

Toublan believes that other instruments should be used in combination with LCDX tranches to hedge CLOs. "For instance, the CDX.HY super-senior tranche is also a good triple-A CLO hedge for overall moves in the high yield credit market, even though difference in default sensitivities between CLOs and high yield products are particularly salient in the current high default conditions," he says.

According to Toublan, LCDX has a much larger overlap with the CLO market than the CDX.HY. He suggests the overlap between a universe of CLOs and LCDX.12 is about 21.7 % by notional amount, although it is lower than expected due to greater diversity in CLO credits (most CLOs have between 100-300 issuers, with average position sizes between 0.5%-0.75%). However, he says the relative lumpiness of the LCDX could serve as a useful hedge against certain CLO portfolios, where overlap is high.

He notes that on a transaction level, the CLO overlap to LCDX.12 ranges from as low as 0% to as high as 45%, and the wide dispersion is roughly the same at the manager level. CDX.HY has an average overlap of 10.6%.

But investors are not convinced that the new LCDX will solve problems within the CLO sector. Jason Pratt, md at Peritus I Asset Management, says: "We're talking about an illiquid asset class here: what is the point of hedging something that doesn't have a firm market price in the first place? If you're an asset manager in these types of tranches, you could take your capital and apply it to the LCDX, but you would still have to take the risk of that further bet."

"The concern remains that if underlying loans default in a CLO, where does that leave the asset manager? I'm not sure that using the LCDX to hedge answers those questions," he adds.

Meanwhile, structured credit analysts at Barclays Capital believe the LCDX retranching could provide opportunities for investors to sell protection on senior LCDX tranches once again. "The 15%-100% tranche had long since lost that allure as investors became more cautious about defaults," they note. "Moreover, the thin junior tranches in the 0%-15% part of the capital structure became irrelevant after index expected losses passed the 15% point." They say the thicker tranches could once again attract investors' risk appetite to the junior part of the capital structure.

"All tranches trade with a 500bp fixed coupon, which matches the fixed coupon of the index. This standardisation should bring some transparency to trade settlements, since calculation of durations becomes less important when determining mark-to-market," the BarCap analysts note.

They also expect capital structure arbitrage trades to be less relevant. "If an investor sells all the standard tranches and buys the index in notional-neutral amounts, the running coupons would be a complete wash. Therefore, the upfront amount on day one should be zero, as well as in the absence of transaction costs. Investors should also make sure that they are indifferent between index and all the tranches as a whole from a margin-posting standpoint."

AC

Ratings

Rating the raters

CRA reform efforts continue apace

Efforts to implement appropriate credit rating agency (CRA) reform continue apace on both sides of the Atlantic. The European Parliament is scheduled to discuss the EU Committee on Economic and Monetary Affairs' proposal for regulating rating agencies today (22 April), while the US SEC held a roundtable to further its oversight of such firms last week.

Association for Financial Professionals' (AFP) president and ceo Jim Kaitz put forward two proposals for credit rating agency reform at the SEC roundtable. The first involves implementing a model that is similar in nature to a utility, in which nationally recognised statistical rating organisations (NRSROs) have a single line of business focused exclusively on providing credible and reliable ratings.

These agencies would be able to interact with and advise organisations being rated, but could not charge fees for providing advice. The new NRSROs would be financed by a transaction fee.

The second of the proposals involves the US government mandating that any federal programmes requiring credit ratings, as well as any business that has had a capital infusion from the government, utilise alternative NRSROs as additional credit analysis providers. According to Kaitz, this action would foster a more competitive environment and give credibility to alternative rating agencies now overshadowed by Moody's and S&P.

He says: "The current rating agency processes and business model are broken. The big two rating agencies were a catalyst for the sub-prime debacle and resulting financial meltdown. The time has come for a fundamental overhaul of the system to restore investor confidence and reestablish efficient global capital markets."

AFP member surveys underscore the ongoing criticism of CRAs, namely that: the information provided by them is neither timely nor accurate; the rating agencies are primarily serving the interest of parties other than investors; and the SEC should increase its oversight of rating agencies and take steps to foster greater competition in the market for credit rating information.

At the same roundtable, S&P president Deven Sharma stressed that his firm has undertaken a number of new initiatives in connection with its ratings and is continuing to think of ways that it can enhance the ratings process. "We are also listening to investors, issuers, commentators, policy makers, regulators and others for new ideas and approaches," he commented in his testimony. "We believe all of these entities need to play an active role in strengthening our markets. We are dedicated to doing our part."

His statement addressed the value of ratings to the markets - both over the years and on a going-forward basis - and the need to restore investor confidence in light of recent events. He also noted the role of regulation in bringing confidence back in ratings, including the importance of broad solutions, globally consistent regulation, the preservation of analytical independence and an appropriate framework for ratings accountability.

"Every business model has positive and negative aspects, and some may work better for certain investors than others," Sharma comments. "In our judgment, the focus of regulation in this area should be on recognising the benefits and costs of different models and working to ensure that potential conflicts are effectively disclosed and managed, so that market participants can decide which rating firms and business models are appropriate for their needs."

Meanwhile, the European parliament is expected to vote either today or tomorrow (23 April) on the EU Committee on Economic and Monetary Affairs' proposal to regulate CRAs. The draft law addresses issues including rating 'shopping', rating comparison and monitoring, the make-up of an agency's board and the implementation of suffixes for structured finance securities.

In terms of addressing ratings shopping, the proposal requires CRAs to disclose information about all structured finance products submitted for their initial review or a preliminary rating. Such disclosure shall be made whether or not issuers contract with the CRA for a final rating. The EU believes that this will enable investors to determine whether issuers sought, but subsequently decided not to use, ratings from a given CRA.

With regard to rating comparison and monitoring, CRAs will have to "record and publish all instances where in its credit rating process it departs from existing credit ratings prepared by another agency with respect to underlying assets or structured finance instruments, providing a justification for the differing assessment". CRAs shall also separate the decision-making process in connection with the original rating from the decision-making process in connection with the review and possible upgrading/downgrading of the original rating of structured finance products.

Furthermore, the majority of members of a CRA's supervisory board (and everyone involved in the compliance function) will be required to have sufficient expertise in financial services. At least one independent member of the board (and all involved in the compliance function) shall have in-depth knowledge of the structured credit and securitisation markets.

Finally, in terms of implementing structured finance suffixes, the draft recognises that it could be "misleading for investors" to apply the same rating categories to corporate debt and structured finance instruments "without further explanation". CRAs are consequently likely to be required to use different rating categories when rating structured finance instruments - for example, by carrying a supplemental annotation - and provide additional information on the different risk characteristics of such products.

Ahead of the vote, Moody's published a report demonstrating how its supplemental risk measures for structured finance transactions - dubbed 'V scores' and 'parameter sensitivities' - will work in practice within the EMEA RMBS sector. V scores are a relative assessment of the quality of available credit information and the potential variability around the various inputs in determining the rating, according to the agency.

The scores are intended to rank transactions by the potential for significant rating changes owing to uncertainty around the assumptions. The agency expects typical transactions in the UK prime, Dutch, French, Italian and German RMBS sectors to be given V scores of low/medium assumption variability.

Irish, Spanish and Portuguese RMBS are expected to be slightly weaker and will likely be awarded V scores of medium. Assumption variability for UK non-conforming and Russian RMBS were the highest of all the EMEA RMBS sectors and are expected to be assessed scores of medium/high and high respectively.

Parameter sensitivity analysis, on the other hand, is designed to provide a quantitative calculation of how the initial model-indicated rating of a structured finance security could vary if key assumptions were changed. For example, if a median expected loss of 0.85% and Aaa credit enhancement level of 4.9% were used in determining the initial rating of a typical prime RMBS transaction from one of the EMEA sectors and these were then changed to 1.28% and 6.9% respectively, the initial model-indicated rating for the senior certificates might change from Aaa to Aa1.

CS & AC

CMBS

Singapore CMBS rated, another refinanced

The first publicly-rated CMBS this year from Singapore is being marketed to investors. The S$520m Winmall (2009 Refinancing) transaction has been assigned ratings by S&P and is a single-borrower single-property commercial real estate securitisation involving secured loans to JPRL, an established joint venture company whose primary business is the ownership of Jurong Point shopping centre.

The deal, underwritten by Overseas-Chinese Banking Corp, is due to close on 27 April. The bonds have a scheduled maturity of five years and a legal final maturity of seven years. The proceeds of the issue will be used to refinance existing debt facilities.

According to Rajiv Vishwanathan, credit analyst at S&P, existing CMBS in Singapore have been performing within expectations. Most transactions are single-borrower multi-property CMBS transactions and are typically three- or five-year interest-only structures, with a bullet refinance requirement.

"There are a number of transactions which are due for refinance in 2009 and thus far all maturities have been successfully refinanced and most issuers are progressing with their refinance strategies," says Vishwanathan. "The refinance risk is clearly a material risk in the current environment, but thus far refinance is occurring within expectations."

Last month a CMBS programme successfully refinanced via bank debt. According to Vishwanathan, it remains to be seen what type of refinancing (whether bank debt, CMBS or other forms) is available for maturing CMBS this year. "There are a number of refinance strategies being explored, including bank debt, CMBS, equity raisings and the like," he says.

AC

Distressed assets

IMF revises write-down estimates to US$4.1trn

The IMF warns in its semiannual Global Financial Stability Report (GFSR) that the challenges to restoring financial stability remain significant. In particular, the deteriorating economic environment has increased expected bank write-downs and raised the need for fresh capital in emerging market banks.

The IMF emphasises the need to clean bank balance sheets of impaired assets. The report uses two scenarios to estimate the amount of capital necessary to restore banks' buffers to levels that the market believes would permit banks to operate in today's environment.

Under one scenario, capital injections totaling US$875bn would be necessary for banks located in the US and Europe using a common measure of leverage - tangible common equity (TCE) to tangible assets (TA) - of 4%, the level prevailing before the crisis. Estimated equity requirements for banks in the US by the end of 2010 are about US$275bn; for the euro area, US$375bn; for the UK, US$125bn; and for banks in other advanced economies in Europe outside the euro area, about US$100bn.

At a somewhat more demanding TCE/TA ratio of 6%, the amount of needed capital rises accordingly. Banks would not necessarily have to raise all of this amount; some of this capital could come from the conversion of preferred shares to common equity or from the implicit guarantees of some governments to cover bank losses on some sets of assets.

The estimates of needed injections are based on the roughly US$2.8trn losses that banks will incur from the start of the crisis through 2010 and reflect losses already taken and bank earnings this year and next that can be used to bolster capital. TCE is essentially total equity, less preferred shares and intangible assets, while TA reflects loans and other common bank assets less intangible assets such as a goodwill that cannot be measured or counted.

For all financial institutions, the report estimates that write-downs on assets that were originated in the US will total about US$2.7trn, up from the roughly US$2.2trn projected in an interim report in January. This figure covers both losses already recognised and those yet to come this year and next, and incorporate a number of assumptions about the economic outlook and financial conditions.

The latest GFSR extends its write-down estimates to include losses on loans and related securities that were originated in Europe and Japan, which will total approximately US$1.3trn. Altogether the IMF estimates that potential write-downs, including about US$1trn already taken, could be nearly US$4.1trn on some US$58trn of assets originated in the US, Europe and Japan.

However, the Fund notes that the assumptions used to make these broader estimates are subject to significant uncertainty. The estimates could be lower depending upon policy actions and more favourable outcomes than assumed.

Nonetheless, banks will likely bear about two-thirds of the US$4.1trn in write-downs, which - together with their exposure to emerging markets - is about US$2.8trn in actual and potential write-downs. Write-downs will also be borne by other financial institutions, including pension funds and insurance companies, the GFSR concludes.

CS

Documentation

CDS guarantee deliverability questioned

The market has historically struggled with the focus of CDS contracts on downstream guarantees that are often economically meaningless in a bankruptcy. Until recently, the answer to this has typically been based on the definition of 'qualifying guarantee' in the 2003 ISDA Credit Derivative Definitions. However, according to structured credit strategists at Barclays Capital, recent credit events involving Abitibi and Chemtura have brought the straightforward nature of deliverability based on guarantees into question.

These credit events also show the importance of guarantees for trading CDS, as they can potentially cause the trigger event or provide a cheapest to deliver option that greatly increases the value of owning protection. The strategists recently undertook an analysis of the guarantee language of credits with holding company CDS and identified trading opportunities based on either orphaning possibilities for holding companies or compression between holding company and operating company CDS.

"We believe the market is uncertain about what constitutes a qualifying guarantee, following the decisions related to Abitibi and Chemtura, and hope that now that the Determinations Committee is in place, a more formal precedent can be set," the strategists explain. "In the credits we examined, we noticed common themes that mirror some of the language in Abitibi and Chemtura. We expect that these issues could be much more complicated in Europe, where capital structures are often more complex with respect to different legal entities."

For some of the names included in the analysis, it is clear whether the guarantee qualifies for deliverability. However, for a number of credits, the answer is more nebulous and the strategists attempt to place these names somewhere on the spectrum between a good qualifying guarantee and definitely not a qualifying guarantee.

The indentures that have the best guarantee language with respect to the ISDA definitions do not even contain a provision for release of guarantees, according to the BarCap analysis. This was true of Charter and, therefore, the bonds of its operating companies were deemed deliverable following the recent credit event.

Other examples with similar strong irrevocable guarantees are Six Flags, Sears, Republic Services and AT&T. For these names, the strategists feel comfortable that subsidiary bonds that are guaranteed will be deliverable into holding company CDS.

At the other end of the spectrum, several issuers have loose guarantee language that they are confident means that the subsidiary bonds are not deliverable into holding company CDS. Intelsat is a prime example, as the guarantee can be released at any time and the longest dated bonds of the reference entity mature in 2013.

"As a result, the curve should trade fairly flat for longer-dated CDS and, even between 2013 and 2015, the recovery from any potential credit event would be much higher than if a credit event occurred before 2013," the strategists conclude.

CS

Distressed assets

Understanding the fundamentals

Mark Hale, Paul Levy, Charles Pardue and Malcolm Perry of The Prytania Group answer SCI's questions

Q: How and when did The Prytania Group become involved in the structured credit market?
Malcolm Perry, ceo: Prytania was established five years ago - with backing from JPMorgan - by Charles Pardue, who was one of the original members of the bank's structured finance team. The move was driven by the realisation that there was a limited amount of buy-side expertise in the structured credit space; that is, many investors weren't in a position to properly analyse such instruments.

Charles Pardue, managing partner: We wanted to build an analytics platform that could handle the data inconsistencies rife in the market: not only was gathering all relevant data problematic, but also having the capability to run appropriate analyses was. Our clients come to us because they may not be able to find an accurate model and in some cases what they hold in their portfolio may not even be visible. We've created tools that rapidly run thousands of scenarios to get a more accurate picture based on probabilistic analysis.

Q: What is your strategy?
MP: Prytania's business is based on two core activities: asset management and risk advisory, both undertaken by Prytania Investment Advisors. Our proprietary analytics are used extensively by Prytania Investment Advisors, but are developed and managed by a different subsidiary, Prytania Services. We spent a number of years building our proprietary analytics platform, with the aim of analysing both individual transactions and portfolios and hopefully licensing it to other institutions. We were also preparing our first fund during this time.

But at that time, during the height of the bull market, we found that there was little interest in analytics because it wasn't seen as a necessary differentiator. So, in a way, what followed was a blessing for us because we'd already developed the necessary tools and expertise to help clients. We advise customers on what to buy, hold or sell, as well as de-mystifying their existing portfolios.

In September 2007, we were among the first firms to take on advisory roles during the current credit crisis - two of which have since become asset management mandates after it became apparent that it's more efficient for us to manage the portfolios directly. When Lehman Brothers defaulted, there was a material kick-up in advisory work because the market came to the conclusion that there is no shame in admitting to its problems.

Paul Levy, partner: Investors are increasingly looking for independent valuations and expertise outside of the investment banks. The problem is that investment banks have not only lost some of their credibility, but they also have very siloed expertise - that is, they are unlikely to be able or willing to provide detailed advisory across a number of different asset classes.

Mark Hale, chief investment officer: It may be too late to deal with certain portfolios, but for others we advise on risk management and hedging matters, as well as changing asset allocation strategies. In terms of restructuring portfolios, this might entail reducing the leverage or taking out the positions altogether. However, it is often difficult to get consensus for such changes.

CP: The risk advisory activity is very complementary to our asset management business. Through the advisory work, we see lots of paper that we haven't purchased to date, but analysing and understanding these positions gives us a better sense of the opportunities in those asset classes going forward.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
MP: The analytics were originally designed for cash and synthetic CDOs and CDO-squareds. But our investment activity has mostly been focused on cash product.

Q: How do you differentiate yourself from your competitors?
PL: The analytics are designed with a long-term perspective and so are robust and scaleable. We are different to many of the recent start-ups seen entering this space because it takes time to build the necessary infrastructure.

Also, we are differentiated from the sell-side firms because their models have typically been developed with solely deal origination in mind. Modelling deals from an origination perspective is completely different to modelling them from a surveillance and relative value perspective.

In this regard, you need to be able to consider the complexity, number and variety of the different underlying assets, as well as the degree of overlap across a portfolio. You also need to be able to provide various sensitivities and emphasise the underlying fundamental credit issues.

The market essentially became blinded by the complexity and forgot about understanding fundamental credit risk. Analysing large, diverse portfolios of structured credit assets requires a difficult combination of depth and breadth that few firms are able to cohesively bring together.

CP: On the documentation side, for instance, you can't simply rely on cashflow models to anticipate what will happen. The results are in some sense binary and identify structural issues rather than credit issues.

Having worked as structurers at investment banks, Paul and I are experienced in digging down into detailed documentation and so can usually identify the critical elements. For example, we looked at 25 different transactions for one client and three of them had material risk issues arising from the documentation - though it's painful work, documentation issues can be a significant source of risk.

An investor can only be confident when they know how their portfolio will perform. The idea is to give clients a more complete understanding of the range of risks they face, so that they can make certain decisions about their holdings.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
MH: Our challenge is to persuade investors about the value out there. It remains difficult to get investor committee backing and even if a chief investment officer is in agreement, they'll often want evidence of someone else doing it first!

I expect it to become a bit easier to demonstrate that value is being captured as 2009 progresses, deals get called and originators show that they can still refinance. It's important to rebuild confidence in the product and the reopening of the new issue market, albeit even if largely only for government-mandated deals, is a positive step.

In terms of opportunities, clearly structured credit is a narrow field and so we've always wanted to broaden our remit - separate accounts are a good way of achieving this. We manage two funds and two separate accounts, with assets under management of approximately US$900m. We're small but growing rapidly, including by potentially tapping our opportunity fund.

We launched our first fund, the US$400m Danube Delta transaction, in August 2006. It mixes ABS CDO and SIV technology to provide more flexible financing via both bank debt and term debt.

Our second fund, an opportunity vehicle called Athena (see SCI issue 90), was launched in May 2008 with US$65.4m. The timing was a compromise with the client and it took around eight months to become fully invested. The assets range from high quality triple-A bonds at great spreads to distressed assets purchased for a few cents.

After the collapse of Lehman Brothers we've begun to see the authorities use monetary and fiscal policy to underpin the financial system and facilitate liquidity. I think investors are now being properly compensated for the risk.

Doubtless there will be further forced selling, with limited demand, so the opportunities will be great for investors prepared to take some mark-to-market volatility and look at the investment from a long-term perspective. If you choose the right assets, they'll achieve a good on-going yield even before pull to par and amortisation are considered, which can boost returns significantly.

PL: But it has become clear that you need to have a three- to five-year perspective on these assets and that having the right delivery mechanism is as important as choosing the right assets. The market didn't properly appreciate liquidity risk before the credit crunch hit and so it's unsurprising that investors are shying away from market-value structures. A private equity-style structure is best for investing in distressed assets; i.e. taking a longer-term view on realisations and only utilising term leverage, if any.

Q: What major developments do you need/expect from the market in the future?
PL: I question whether we'll see any primary arbitrage deals any time soon. So much needs to happen before structured credit issuance activity re-emerges.

Banks are the primary originators of credit risk and it still makes sense for institutional investors to access credit risk, so the originate-to-distribute model is still valid in an appropriate format. But this will need a distribution mechanism via some form of vehicle and suggests that demand for some form of tranched or unlevered fund will remain.

Another issue is capital treatment and regulatory oversight of the asset class and formats it can be delivered in. The market still needs clarity around this.

MH: I agree that we're unlikely to see much non-government mandated new issuance any time soon and so as the supply/demand imbalance tilts over the next year, this should mean that asset prices rise quite quickly on the rebound. Over the last few months, the markets appear to have moved on from the 'shock and awe' of the crisis towards needing a battle plan for how to deal with their assets and portfolios. Investors certainly seem to have a more coherent approach now.

There seems to be an element of cynicism about government-mandated new issues. But the flipside is that regulators have finally recognised the powerful role securitisation has in the market in terms of getting cash into consumers' hands.

Nevertheless, a significant financing gap remains. To move forward, the market needs to mobilise sources of funds where they're available - i.e. pension funds and insurance companies - and persuade them of the returns, relative liquidity and subordination available at gilt-equivalent volatility for some key senior ABS markets in particular.

At the margin, government-mandated ABS would also be suitable investments for high net-worth investors or private banks. But ultimately, the market needs greater confidence about a self-sustaining environment and the current unease about government interference takes us further away from that goal.

About The Prytania Group
The Prytania Group is a group of global companies focused on the finance industry. It is comprised of Prytania Investment Advisors, an asset manager and risk advisor specialising in structured finance; Prytania Services, a software developer specialising in financial analytic and monitoring applications for the structured finance industry; and Prytania Holdings, a holding company providing administrative support to the two other companies.

CS

Boutique adds four for trading group

The latest company and people moves

Maxim Group has appointed four fixed income veterans to bolster its structured credit sales & trading group.

Kurt Kaline has been named md of CMBS trading and will be responsible for sourcing and trading CMBS and CRE debt. Prior to joining Maxim Group, Kaline was an md with Winthrop Realty Partners, where he was responsible for the purchasing and surveillance of all CMBS as well as sourcing commercial real estate debt for the Concord Debt Platform. Previously, he served as the director of CMBS trading for ABN AMRO/LaSalle Financial Services, where he was responsible for new issue CMBS distribution and secondary trading.

Robert Cestari was named director of CMBS trading and will be responsible for sourcing and trading CMBS and CRE debt. Prior to joining Maxim Group, Cestari was also an md with Winthrop Realty Partners, where he established the firm's debt acquisition and CDO issuance platform, Concord Debt Holdings. Previously, he was with Apollo Real Estate Advisors, where he focused on sourcing and underwriting commercial real estate-related debt products.

Matthew Christ was named director of structured credit sales, where he will be responsible for marketing RMBS, ABS and CMBS related securities. He began his career with BT/Alex Brown, where he worked as a banker on various equipment and asset-backed securitisations.

He later joined Merrill Lynch, where he held a number of positions in the origination, marketing and sales of structured credit products and derivatives over his 10-year career with the firm. Prior to joining Maxim Group, Christ focused exclusively on marketing structured credit to hedge funds and money managers.

Finally, Robert Clark has been named director of structured credit sales, responsible for marketing RMBS, ABS and CMBS related securities. Clark brings over two decades worth of structured credit sales and management experience to Maxim Group.

He was most recently with Cohen & Company, where he specialised in mortgage-related securities. Prior to that, Clark held various sales management responsibilities with WAMU Capital Markets, RBC Capital Markets and Prudential Securities.

"We are very pleased to welcome these industry veterans, who bring a wealth of experience to our fixed income capital markets platform, which continues to enjoy robust expansion," comments Armand Pastine, executive md and head of Maxim Group's fixed income division. The firm also recently hired former Goldman Sachs vp and Barclays director, Colin Campbell, as md of structured credit sales & trading.

Broker names traders for new ABS desk
Evolution Securities has expanded its fixed income business by hiring two ABS traders from Société Générale in London. Alexander Lazanas was formerly head of ABS trading, while Rajan Dosanjh was formerly vp of ABS trading at the bank.

Lazanas and Dosanjh will be responsible for launching Evolution's ABS trading desk. Both will report to Guy Cornelius, head of fixed income.

Prior to joining Société Générale in 2005, Lazanas spent four years at West LB, having joined as a graduate trainee, and worked across all areas of credit trading. Dosanjh was vp of Société Générale's ABS trading division for four years from 2004. He began his career in asset securities trading in 2000 with Commerzbank.

Pre-event driven manager hires pair
Simran Capital Management, a 'pre-event driven' activist investment manager focusing on stressed and distressed credit markets, continues to grow in order to take full advantage of the historic dislocation between market and recovery values. The firm has added two key new hires intended to expand its existing non-investment grade fixed income portfolio management expertise.

Steve Cooke and Shawn Groves have joined Simran as senior portfolio managers, assuming portfolio management responsibilities in connection with the firm's existing and new funds. With these hires, the firm will also be expanding its presence by opening an office in Dallas, Texas, to supplement its existing base in Chicago, Illinois.

Cooke was most recently at SMH Capital Advisors, where he was part of the high yield bond portfolio management team overseeing over US$2bn of funds and separately managed accounts. At SMH, Cooke was instrumental in numerous in- and out-of-court restructurings and served on and chaired many official and ad-hoc creditors' committees. He has been in the investment business for over 15 years, gaining experience at Goldman Sachs, Lehman Brothers and Loomis Sayles, among others.

Groves joins Simran from Highland Capital Management, where he was a portfolio manager covering the cable, media and communications sectors, overseeing US$6bn of domestic and international high yield bonds, leveraged loans, equities and derivatives. At Highland, Groves originated and structured several leveraged corporate transactions, led corporate restructurings for various firms and co-established a European fund platform. He has over 11 years of industry experience at Citigroup and Verizon, among others.

Alternative asset manager recruits ABS duo ...
Belstar Group, a private investment firm specialising in alternative and real asset investment strategies, has appointed Simina Farcasiu and Jeffrey Moses.

Farcasiu joins as a partner of the Belstar Group and senior portfolio manager for the Belstar Credit Fund (see below). She has 20 years of fixed income and structured product experience.

Before joining Belstar Group, she was a senior md at Bear Stearns, and later JPMorgan Asset Management. As the senior portfolio manager, Farcasiu was responsible for the overall strategy, portfolio construction and trading for the Bear Stearns Structured Risk Partners Master Fund.

Moses joins Belstar Group as md and director of ABS research and analytics. Moses joins the firm from HSBC, where he was the md responsible for ABS and structured bonds for the Americas.

In this capacity, he was responsible for the securitisation business in the Americas and for managing a 16 person banking, syndicate and analytics team. Before joining HSBC Moses was an md at Bear Stearns, responsible for ABS.

... and launches TALF funds
Belstar Group has launched the Belstar Credit Fund and the Belstar Altair Credit Fund, both of which have participated in recent TALF fundings administered by the US Federal Reserve. The funds are designed to achieve attractive returns by investing in a portfolio of highly rated ABS eligible to be financed through the TALF programme.

Simina Farcasiu, a partner of the Belstar Group (see above), will be the senior portfolio manager for the funds. "These funds offer private sector participants opportunities that are designed to expand the supply of credit in the US and support fundamental economic activity," comments Daniel Yun, founder and chief executive of Belstar Group. "In Simina and Jeff, we have investment professionals who have a extensive knowledge of the US asset-backed securities market. They add another dimension to Belstar's nimble expertise that we believe will effectively deliver new investment opportunities to clients around the world."

"These opportunities arise out of unprecedented dislocation in the credit markets," says Farcasiu. "Without the overhang of legacy assets or other conflicts, the Belstar Group has built a TALF-platform that effectively addresses today's markets."

Morgan Creek hires in credit
Morgan Creek Capital Management has announced that Sam DeRosa-Farag has joined to help lead its efforts in the credit sector. Prior to joining Morgan Creek, DeRosa-Farag was president of Ore Hill Partners, where he was a member of the investment committee. While at Ore Hill, he was primarily responsible for new initiatives, including structured products and risk management.

Prior to joining Ore Hill, DeRosa-Farag was md of the global leveraged finance strategy and portfolio products group and co-head of the high yield research department of Credit Suisse. He joined the firm from Donaldson, Lufkin & Jenrette, which Credit Suisse acquired in 2000. At DLJ, DeRosa-Farag was an md and head of fixed income research.

Markit appoints SF pricing services head
Markit has appointed Neil McPherson as an md in New York to manage and expand its structured finance pricing services. McPherson will be responsible for Markit's US RMBS pricing service, its European ABS service and its North American ABS CDS service. He will report to Kevin Gould, president of Markit North America.

McPherson comes from NewOak Capital, which he joined at the end of September 2008 (see SCI issue 106). Previously, he was an md and head of the ABS syndicate desk at ABN AMRO in New York. Prior to that, he was an md at Credit Suisse First Boston in New York, where he led ABS and CDO research.

Asset manager mints TALF investment funds
Paramax Capital Partners has embarked on a new investment management initiative focused on the attractive investment opportunities offered by the US Treasury's TALF programme and other related government asset and liquidity programmes. In connection with this new initiative, the asset manager - which was one of the first firms to participate in fundings through the TALF programme - is to launch two new funds.

The funds, which will be open to outside investors and are expected to raise US$100m each, will invest in TALF-eligible securities. Investors will be able to participate in the TALF funds directly or through separate accounts. The funds' investment activities will be led by Tom Dial, Jeb Ebbott and Al Hageman -experts in consumer ABS, MBS and whole loans, who have decades of experience in senior roles at firms including Citi, Bear Stearns and Lehman Brothers.

"The TALF programme has the potential to revive vital securitisation markets and increase the availability of consumer credit in this country, while also creating attractive investment opportunities for institutional and other investors," says Paramax ceo Gordon Baird. "Paramax anticipates being an active participant in the TALF programme."

The asset manager says it has invested in developing the infrastructure and personnel necessary to sponsor and manage TALF and related investments, and will continue to be a significant participant in Treasury-sponsored programmes, provided the programmes continue to be designed and implemented in a way that is attractive to private sector participants.

Babson adds four in business development
Babson Capital has added four new team members to its global business development group. New to the group are Mark Sullivan and Jeffrey Stammen, who join the group's sales team and will be based in Los Angeles and New York respectively, and Joshua Leventhal and Loren Sageser, who join as product managers and will be based in New York and Charlotte respectively. Leventhal will be responsible for alternative strategies, while Sageser will be responsible for investment grade, high yield and various other debt-related separate strategies.

Sullivan was recently md and Public Funds/Taft-Hartley Marketing & Client Service team leader for FAF Advisors. He has more than 15 years of experience in public funds and Taft-Hartley marketing, and previously worked for Paulson & Co, Banc One Investment Advisors and A.G. Bissett & Co.

Stammen joins Babson Capital from Wachovia Capital Markets, where he worked most recently as director of alternative investment sales. He has 13 years of experience working in the area of structured credit products, fixed income derivatives and MBS, and previously worked with Citigroup Private Bank, UBS Investment Bank, CIBC World Markets and Citigroup/Salomon Smith Barney.

Leventhal comes to Babson Capital from JPMorgan, where he served as executive director in the capital introductions group dealing with hedge funds. He has 12 years' experience in the financial markets working with credit, structured credit and alternative investments. He previously worked in structured credit products at Bear Stearns and with Foothill Capital Corp.

Sageser comes to Babson Capital from Wachovia Capital Markets, where he was vp of structured debt finance, serving as lead deal structurer and distribution manager for Wachovia's credit opportunity and bank-loan fund platform. He previously worked with fixed income asset manager Churchill Pacific, private equity fund of funds Horsley Bridge Partners and the Franklin Templeton Group.

Bank expands in structured products
Morgan Joseph has appointed David Vegh as a vp with the firm's structured products group. Vegh's experience includes structured products sales positions with BB&T Capital Markets and Legg Mason Wood Walker, in addition to a stint with Fitch.

BlackRock acquires R3
BlackRock has entered into an agreement with R3 Capital Management to assume management responsibility for R3's multi-strategy credit hedge fund with US$1.5bn in assets under management. Rick Rieder, president and ceo of R3 Capital Partners, is joining BlackRock as md and head of its fixed income alternatives portfolio team and will continue to manage the R3 funds at BlackRock. He was formerly head of Lehman Brothers' global principal strategies and credit businesses, and has over 22 years of industry experience.

He brings with him a team of seasoned professionals, with expertise in portfolio management, trading, analysis and research. The senior team members who will be joining BlackRock as mds are Richard (Dik) Blewitt, Russell Brownback, Leland Hart, Michael Lipsky, Mike Phelps, John Stein, Josh Tarnow, Paul Tice and Michael Weaver.

Further, two additional investment professionals are joining BlackRock. Akiva Dickstein has joined as an md to head its mortgage portfolio team. He previously spent eight years at Merrill Lynch, where he served as md and head of the US rates and structured credit research group.

Randy Robertson has also joined as an md to co-head the securitised assets investment team. Robertson spent 11 years with Wachovia Capital Markets, most recently as md, head of the residential mortgage and consumer group, and co-head of residential CDOs.

CIO hired, fund integrated
Cheyne Capital Management has appointed Chris Goekjian as partner and chief investment officer, reporting to Jonathan Lourie, chief executive. Goekjian will have overall responsibility for risk management of all Cheyne funds and investment products, oversight of portfolio management teams and development of new investment products. Most recently, he was ceo and cio of Altedge Capital, a London-based fund of funds manager that he founded in 2001 and whose business is intended to be integrated into Cheyne over the next six months, subject to legal and regulatory approvals.

Goekjian has over 25 years' experience in investment and risk management. His previous experience includes serving as head of the global fixed income division of Credit Suisse's investment bank, where he oversaw more than US$300bn of trading positions.

RBC hires real estate co-head
RBC Capital Markets has appointed John Case as an md and co-head of the firm's US real estate investment banking group. He will be based in New York and report to Peter de Vos, RBC's head of US global investment banking (GIB). Case will also join the US GIB management committee.

Case will team with co-head Kevin Stahl to expand the firm's US real estate business, utilising RBC's strength and stability to deliver the full breadth of the firm's global capabilities to its real estate clients. Case brings more than 20 years of real estate investment banking and finance experience to RBC. Prior to joining RBC, he was co-head of Americas real estate investment banking at UBS, beginning in 2006, and was responsible for leading the firm's business activities with commercial real estate clients.

ISDA names four new directors
ISDA has elected eleven board directors, seven of whom currently serve on its board. The four new directors are: Brian Archer, md and global head of credit trading at Citi; Jonathan Hunter, md and global co-head, fixed income and currencies at RBC Capital Markets; TJ Lim, global co-head of markets at UniCredit; and Nobukazu Saeki, deputy general manager at Mitsubishi UFJ Securities Co.

CDPC repurchases sub notes
Primus Financial Products has purchased US$21.9m principal amount of its US$75m subordinated notes due 2034 in a privately negotiated transaction, following an inquiry to Primus Financial made by the holder of the notes. The company purchased the notes for US$7m in cash, with the transaction expected to result in a realised gain of approximately US$14.6m for Primus Guaranty in Q209. At current market interest rates, the transaction is also expected to result in annual interest expense savings of approximately US$700,000 for Primus Guaranty.

The repurchase is part of the company's strategy to amortise Primus Financial's credit swap portfolio. The transaction is separate from Primus Guaranty's debt and equity repurchase programme, the company notes.

Reduced dividend for Carador
The board of Carador has declared an interim dividend of €0.0131 per ordinary share in respect of the quarterly period ended 31 March 2009. US dollar class shareholders will receive US$0.0173 per share.

According to the permacap, the reduced level of dividend for the quarter reflects several factors including: (i) a greater percentage of cashflows received were allocated to principal (42.97% in the period 1 January 2009 to 31 March 2009, compared with 18.56% in the same period in 2008), as a result of lower estimations of future cashflows and the fact that the company's pricing policy caps the income component of any CLO distribution (annualised) to 20% of the original investment, with any excess reallocated to principal; (ii) the impact of the increased level of cash in the portfolio which, as at 28 February 2009, represented 28.1% of the portfolio; and (iii) the spike in Libor rates seen in October negatively impacted January cashflows, as a result of CLOs resetting their cost of debt during that month, while the loans in the underlying portfolios reset over different periods, taking advantage of falling rates.

As at the close of business on 31 March 2009, Carador's unaudited net asset values per share were €0.4729 (monthly performance of -0.84%) and US$0.6062 (-0.46%). These calculations include an estimated €401,467.51 of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0028 or US$0.0037 per share.

QWIL embarks on share buyback
Queen's Walk Investment Ltd has entered into an irrevocable, non-discretionary arrangement with Citi and JPMorgan Cazenove to repurchase on its behalf ordinary shares in the company for cancellation during the close period commencing on 17 April 2009 and ending on or around 17 June 2009, being the proposed date for the publication of the company's year-end results to 31 March 2009. The maximum price to be paid shall be not more than 105% of the average of the middle market quotations for the company's shares for the five business days before the day on which purchase is made.

JPM Caz and Citi will have the authority to consider, on each trading day, repurchasing more than 50% of the average daily trading volume of the company's shares traded over the 20 trading days preceding that date. The sole purpose of the share buyback is to reduce the capital of the company. The share buyback will be effected in accordance with Chapter 12 of the listing rules and with the company's current authority granted to repurchase up to 14.99% of its issued share capital as of 4 September 2008.

GAV decrease for Volta Finance
As of the end of March 2009, the gross asset value of Volta Finance Ltd was €51.3m or €1.70 per share, a decrease of €0.09 from €1.79 per share at the end of February 2009. During the monthly period the company paid a dividend of €0.06 per share.

The March mark-to-market variations of Volta Finance's asset classes were: +8.5% for ABS investments, -9.7% for CDO investments and +3.5% for corporate credit investments.

In March, declines in prices have been on average almost compensated by generation of cashflows. The company attributes the decline in most of the CDO prices to the numerous downgrades by S&P and Moody's in the underlying loan portfolios, as well as the severe and numerous downgrades of CLO tranches by S&P following the recent changes in its methodology.

Fund administrator and solutions provider tie up
Fund administrator Admiral Administration has teamed with hedge fund solutions provider Paladyne Systems to offer what it describes as an innovative technology and services solution to alternative investment managers. Admiral has licensed the PALADYNE product suite as a comprehensive middle-office services platform, which is fully integrated with its existing portfolio accounting system, Advent's Geneva. Admiral has also obtained distribution rights to provide its clients with direct access to Paladyne's products as an integrated client-facing technology offering.

Admiral will utilise Paladyne's Application Service Provider (ASP) solution for hosting, disaster recovery and ongoing IT support for both Paladyne's products as well as Advent's Geneva. By leveraging the ASP model, Admiral can provide its clients with web-based access to Paladyne's front-office trading, portfolio management, real-time P&L and custom reporting tools. As an end result, Admiral and its clients will share an integrated technology platform resulting in an expanded services offering, tighter operational control, increased transparency, more timely reporting, cost reduction and scalability, and seamless communication between Admiral and its clients.

AC & CS

Japanese CDS CCP under consideration

A round up of this week's structured credit news

Tokyo Financial Exchange (TFX) has released the results of its study on establishing a CCP for OTC derivatives transactions by October 2009. Based on the needs of market participants and the direction of policy discussions by regulators, a committee decided that central clearing facilities should target CDS and interest rate swaps.

Since participants in the interest rate swap market do not necessarily participate in the CDS market and vice versa, the committee agreed that it would be better for clearing members to be different for each asset class. One of the main points under discussion concerned the question of how to manage OTC transactions where the contractual entity is based outside Japan. Many OTC transactions that take place in Japan are recorded in a global book and the contract is held by the foreign entity that controls this book.

Some committee members pointed out that the introduction of a CCP was not a pressing issue since the number of the market participants and the trading volume of the CDS market in Japan is small. There was also the opinion that a CCP for CDS will be necessary in Japan as the proper financial market infrastructure needed for the development of the Japanese CDS market.

Moreover, some committee members thought that once a CCP for CDS was established in Europe and the US, the establishment of a CCP in Japan would become necessary. In order to use a CCP in Japan, it will be necessary for foreign firms to operate through a Japanese clearing member.

However, according to foreign clearing institutions, clearing members say they do not have the resources to implement the back office systems necessary to support such a mechanism. Committee members nonetheless expressed the opinion that foreign-affiliated financial institutions would participate as clearing members in Japan if the use of the CCP was made obligatory through regulation.

The first contract to be processed by the CCP is likely to be a CDS index composed of Japanese companies. After that, liquid single name CDS that are constituents of the index may be added.

End-2008 CDS notionals at US$38.6trn, ISDA
ISDA has announced the results of its Year-End 2008 Market Survey of privately negotiated derivatives. The notional amount outstanding of CDS was US$38.6trn at year-end, down 29% from US$54.6trn at mid-year 2008. CDS notional outstanding for the whole of 2008 was down 38% from US$62.2trn at year-end 2007.

The decreases compared to prior-year periods underscore the success of the industry's portfolio compression efforts, in which firms reduce the number of trades outstanding without affecting their risk profiles, according to ISDA. The survey monitors CDS on single names and obligations, baskets and portfolios of credits and index trades. The US$38.6trn notional amount was approximately evenly divided between bought and sold protection: bought protection notional amount was US$19.5trn and sold protection was US$19.1trn, with a net bought notional amount of US$400bn.

"The lower notional amounts outstanding in this year's survey reflect the industry's ability to quickly and effectively respond to changing market conditions," states Robert Pickel, executive director and ceo, ISDA. "In the current environment, firms are intensely focused on shrinking their balance sheets and allocating capital most productively. They are also looking to increase operational efficiency. Both of these factors drove a decrease in the level of derivatives notional outstanding compared with mid-year 2008."

The Association notes that the notional amounts are an approximate measure of derivatives activity and reflect both new transactions and those from previous periods. The amounts, however, are a measure of activity, not a measure of risk.

As of June 2008, gross mark-to-market value was approximately 3% of notional amount outstanding of all products. In addition, net credit exposure (after netting but before collateral) is 0.6% of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of US$450.4trn as of 31 December 2008, gross credit exposure before netting is estimated to be US$13.5trn and credit exposure after netting is estimated to be US$2.7trn.

All notional amounts have been adjusted for double counting of inter-dealer transactions. In this survey, 63 firms provided responses on credit derivatives.

Debut determination made by ISDA committee ...
ISDA's Credit Derivatives Determinations Committee for the Americas held its first meeting on 16 April. The Committee determined that a credit event occurred for General Growth Properties (GGP), the second-largest US mall owner, and Bowater Incorporated, the newsprint manufacturer. Each company has announced that it had voluntarily filed under Chapter 11 of the US Bankruptcy Code.

The Committee also determined that a CDS auction will be held for Bowater. ISDA will facilitate the process by publishing the auction terms in due course. This will be the first auction terms published pursuant to the Determinations Committees Rules that went into effect on 8 April (see last week's issue).

... while GGP LCDX auction called ...
In response to the General Growth Properties (GGP) bankruptcy filing on 16 April, Markit LCDX index dealers have voted to run a credit event auction to facilitate settlement of LCDS trades referencing the company, which is a constituent of series 8, 9 and 10 of the LCDX index. The auction terms, including the auction date, will be determined by LCDX dealers according to LCDS auction rules published by ISDA.

GGP is included in all of the LCDX indices and the loans are trading at around US$20, according to structured credit analysts at JPMorgan. They find that it has about US$91.5m exposure (in terms of first lien loans) in the outstanding CLO universe.

Meanwhile, R.H. Donnelley (RHD) missed a US$55m interest payment on 15 April 15 and, if it isn't repaid within the 30-day grace period, CDS and LCDS credit events will be triggered. R.H. Donnelley is a member of CDX.HY series 7-12 and LCDX series 8-12, and is among the top-50 obligors in CLOs (with about US$924m exposure or roughly 0.3% concentration in the outstanding CLO universe, according to JPMorgan).

Six Flags also announced on 15 April that it will delay a US$7m interest payment, which could trigger CDS and LCDS credit events if the payment is not made within the 30-day grace period. Six Flags is a member of all CDX.HY indices and all LCDX indices, with at least US$73mn first lien exposure in CLOs.

... and five other CDS settlement prices decided
Five CDS settlement auctions took place last week. CDS on Great Lakes and Chemtura were settled at 18.25 and 15 respectively on 14 April, with 11 dealers taking part in both auctions.

CDS on The Rouse Company were settled at 29.25 (with 11 dealers participating) on 15 April, while the final price of the LyondellBasell auction on 16 April was determined to be 2 (with 14 dealers participating). Finally, on 17 April the final price for Abitibi CDS was determined to be 3.25, with 11 dealers participating in the auction.

This week will also see a string of CDS settlement prices determined. Credit event auctions are scheduled for Charter Communications Holdings (whose CDS and LCDS were settled at 2.375 and 78 respectively, with 11 dealers participating), Capmark Financial Group (CDS) and Idearc (CDS and LCDS) on 21, 22 and 23 April respectively.

Home price index declines further ...
According to JPMorgan's February 2009 Home Price Update, the LoanPerformance home price index shows that home prices dropped by -16.96% year-over-year in February, which is consistent with January's drop of -17.58%. The cumulative price decline from its peak in July 2006 is currently at -32% nationally, but prices are expected to experience another -20% drop before the market hits a bottom in 2010 or even 2011. This will result in approximately -45% cumulative peak-to-trough home price declines, analysts at the bank note.

After adjusting for estimated downward revisions in the data as well as seasonality, JPMorgan projects the annualised monthly decline in February to be -20.44% versus -15.62% in January. However, the housing market will likely gradually improve as government actions come into effect and conforming mortgage rates will have been at an exceptionally low level for an extended period of time (currently at 5%).

Ohio experienced the largest monthly price declines of -27.97% in January (annualised not seasonally-adjusted); Georgia and California came close at -27.20% and -27.07% respectively.

... while additional private-label RMBS losses forecast
Legacy assets remain an ongoing concern for US banks, with losses that could still reach high into the hundreds of billions of dollars. To get a sense of how deep those losses could be, S&P's Market, Credit & Risk Strategies (MCRS) group reviewed the total amount of private-label RMBS outstanding, as well as their current performance record. As part of its analysis, the group also measured the progress of the payments of underlying mortgages that will lead to the wind-down of these structures.

The key findings of this analysis indicate that, with more than US$4trn in mortgages securitised since 2004, the legacy assets remaining on the balance sheets of banks continue to unwind themselves through repayments and defaults, leaving a total remaining balance of US$2trn so far. Prime, Alt-A and sub-prime RMBS transactions totaled US$3.7trn in issuance since 2004 and through repayments and defaults the outstanding balance remains at US$1.7trn.

The MCRS group expects total additional losses from the legacy assets to reach US$260bn (US$165bn from sub-prime, US$90bn from Alt-A and US$5bn from prime RMBS). In a worst-case economic scenario, the group would expect US$375bn in total losses (US$235bn from sub-prime, US$132bn from Alt-A and US$10bn from prime).

Given that the securitised structures assumed a certain loss percentage before equity tranches began to suffer losses, even relatively low non-performing balances in prime mortgage structures would be damaging to equity-tranche investors, according to the analysis. A total of US$250bn in loans is in bankruptcy, foreclosure or REO; though banks will recover a percentage of these balances through the sale of properties, such properties are likely to keep home prices depressed.

Minimal growth for CDS notionals, DTCC
According to the latest DTCC data, gross CDS notionals grew by only US$53bn this week as the overall market nudged back above US$28trn. While there have been significant shifts in several sectors and single names from a risk perspective, analysts at Credit Derivatives Research remain convinced that CDS market participants are primed (either long or short) but unwilling to add/remove risk en masse in this market - potentially waiting for the equity market to leg one way or another.

Index notionals saw only a 0.55% rise to US$9.2trn, indicating that general risk remained flat across the indices. Single names saw a very small 0.09% rise (US$14.3bn) in gross notionals, but remain the largest segment at US$15.17trn. Tranches continue their up-down-up trend, meanwhile, with a drop of 0.3% (US$11.1bn) to US$3.64trn as liquidity is focused in the IG9 and older vintages and seemingly many desks are in run-off mode.

"It appears we are still seeing the hangover effect of the index and single name rolls and the uncertainties around the SNAC as playing on credit market participants' willingness to commit new capital," the CDR analysts note.

EC approves UK ABS guarantee scheme
The European Commission has approved, under EC Treaty state aid rules, the UK's ABS Guarantee Scheme for triple-A rated RMBS. (See separate news analysis for more). Under the scheme, investors will benefit from the guarantee provided to securities issued by SPVs collateralised with residential mortgages. Guarantees allocated under the scheme will be limited to a total of £50bn.

The EC found that current conditions on the financial markets justify the scheme, which aims at facilitating banks to acquire liquidity and underpin lending to the UK real economy. The Commission therefore concluded that the UK support measures are compatible with EC Treaty rules allowing aid to remedy a serious disturbance in a Member State's economy.

Competition Commissioner Neelie Kroes comments: "The Commission is satisfied that this measure will help to reactivate the UK RMBS market and facilitate the restoration of more competitive mortgages for UK borrowers whilst avoiding disproportionate distortions of competition."

On 17 April 2009 the UK declared its intention to establish another scheme to alleviate the funding constraints that banks are currently suffering. The measure is focused on mortgage lending and intends to restore one of the main sources of leverage that UK banks used. The instruments eligible under the ABS scheme are bonds issued by vehicles sponsored by UK banks and building societies that have a substantial business in the UK.

EU sub-IG default expectations rise sharply
S&P expects more than 30% of Europe's non-investment grade companies to default - having sharply increased its default expectations in the face of the downturn in the real estate and construction sectors, the sharp rise in unemployment, reduced consumption and investment and the liquidity squeeze on high yield issuers. The agency expects 30%-35% of all sub-investment grade companies will file for bankruptcy, miss payments or face forced restructuring before the end of 2011. This compares with a default rate of 23% from peak to trough after the dotcom bust.

S&P reports that defaults surged in Q408, with 22 companies failing - more than in the last four years combined. It expects 112 high yield companies to default this year and next.

Favourable seasonal effects expected for ABX
Historically, the March collection period has yielded improving delinquency performance in each year since 2001, according to ABS analysts at Barclays Capital. In the upcoming April 2009 remits, favourable seasonal effects should continue to keep the growth of delinquencies checked.

The analysts expect serious delinquencies to increase by 50bp, 60bp and 140bp for the 06-1, 07-1 and 07-2 series respectively - a smaller rise than last month. Series 06-2 will likely post a larger increase in serious delinquencies than last month (90bp versus 80bp) because the early stage delinquencies for two RFC deals in this series spiked last month as a result of rapid re-defaults of previously modified loans.

"Given the slightly improved liquidation rates last month and three more business days in April versus March, we think CDRs will post a moderate increase of 10bp-70bp this month for the four ABX indices, despite a shrunk REO bucket," the analysts note. "Voluntary prepayments should also benefit from the higher day count and we think CRR will remain flat or rise slightly for the 06-1 through 07-1 series. The 07-2 series continues to come off the peak of first rate reset and should post a small decline in CRR."

Nationwide REO inventories declined by -1.6% to 825,000 homes in February, with a flat to 1% increase expected in March.

CDS trade processing continues to improve
ISDA has released the results of its 2009 ISDA Operations Benchmarking Survey. The Survey show that trade processing continues to improve, especially in regard to confirmations outstanding.

Credit derivatives, for example, show an average across all respondents over 2008 of 3.8 business days' worth of outstanding confirmations, compared with 6.6 days for 2007. Most other products showed similar improvements, the Association notes.

This reduction in outstanding confirmations has occurred, despite widespread dislocations in various financial markets. OTC derivative event volume increased by 2%, where events include new trades as well as actions such as novations and terminations. Increases occurred in commodity, interest rate and credit derivatives, particularly at large firms, while overall equity derivative and currency option event volumes decreased. Last year, in comparison, OTC derivative event volume grew by 38%.

Automation of processing functions also continues to progress, with credit derivatives showing by far the highest degree of automation of operational processes.

New TALF loan terms announced
The US Federal Reserve Board has announced two new interest rates applicable to loans extended under the TALF programme for May funding round. Subscriptions for the May funding will be accepted on 5 May and the loans will settle on 12 May.

The interest rate for TALF loans secured by ABS with a WAL of less than one year will be the one-year Libor swap rate plus 100bp. The interest rate for loans secured by ABS with a WAL of one year or more but less than two years will be the two-year Libor swap rate plus 100bp. The interest rate on loans secured by ABS with a WAL of two years or more will continue to be the three-year Libor swap rate plus 100bp.

Big bang set to enhance liquidity of liquid CDS
Fitch Solutions' latest global liquidity scores commentary confirms that the implementation of the CDS big bang in the US market on 8 April was responsible for a reduction in liquidity last week. To an extent, this had been anticipated due to concerns that market participants would not be able to complete upgrading their platforms in time to cope with the changes, the agency notes.

Critically, the market improved by the close of business on 9 April and the index closed on Friday 17 April at 10.10. In terms of the future impact of the big bang on market liquidity, Fitch expects to see liquid securities become more liquid as a result of these changes. However, it remains to be seen whether these changes will have any impact on those credits that are already suffering from low liquidity.

The commentary also shows that Latin America continues to dominate liquidity in the sovereign CDS market, with Mexico taking top spot again. Thailand continues to remain in the top-five as political unrest in the country led the prime minister to extend the existing state of emergency on 12 April.

The financial sector continues to dominate liquidity in the US market, with General Electric Capital Corporation retaining top spot, closely followed by Citigroup. Ford Motor Credit Company is now the second most liquid name.

Meanwhile, telecommunications companies continue to dominate liquidity in the European CDS market, taking the top three spots. Financial institutions had dominated the top 10 in recent weeks, but many have now dropped out, leaving RBS as the highest-placed financial institution in sixth spot.

PCCW-HKT Telephone takes top spot in the Asia Pacific, due to increasing uncertainty about the US$2.2bn bid from PCCW chairman Richard Li to take it private.

Monoline's ratings affirmed
S&P has affirmed its triple-A counterparty credit and financial strength ratings on Financial Security Assurance Inc and removed them from credit watch, where they were placed on 8 October 2008, with negative implications. The outlook is negative, however.

At the same time, the agency affirmed the single-A plus counterparty credit rating on Financial Security Assurance Holdings and removed it from credit watch developing. The outlook on FSA Holdings is developing.

Assured Guaranty Ltd. (Assured) announced that it had reached an agreement with Dexia to acquire FSA Holdings on 14 November 2008. In S&P's view, the amount of work that remains in finalising all the points of the transaction and evaluating any risk to Assured and FSA translates into a remaining time horizon that extends beyond its defined time window for resolving the credit watch status of ratings.

The transaction has been structured in principal to exclude the risk associated with FSA's financial products business. The financial products unit is expected to remain under Dexia's ownership, with the risk of this business to Assured and FSA limited by, among other things, guarantees from the Belgian and French governments. The negotiations among Assured and Dexia on the finalisation of the form and content of the guarantees for the financial products unit have taken longer than expected, notes S&P.

The outlook reflects the agency's opinion that FSA's franchise has been damaged by its mortgage-related losses and the risk presented in its financial products business. Furthermore, Dexia has characterised FSA as a non-core unit. S&P believes FSA's ability to raise capital and access liquidity is very strongly linked to and limited to Dexia.

The agency says it will likely revise its outlooks on both FSA and FSA Holdings to stable if Assured completes the announced acquisition of those companies. If the transaction fails to close, it believes that FSA would be in a more difficult position, so it could lower the ratings. Under this ownership structure, FSA's ability to raise additional capital would be very questionable, as would its ability to write business in volumes that would support the ratings.

CRE CDO delinquencies continue rising ...
21 newly delinquent assets led to an increase in US commercial real estate loan (CREL) CDO delinquencies to 6.5% for March 2009, up from 5.4% in February 2009, according to the latest CREL CDO delinquency index (CREL DI) from Fitch Ratings. 28 CREL CDOs contained at least one delinquent loan, with individual delinquency rates ranging from less than 1% to 22.1% of the CDO par balance, as of the March 2009 reporting period.

In contrast to the recent trend of limited repurchases, six assets (27bp of the CREL DI) were repurchased from three different CDOs in the March reporting period. One asset manager repurchased two assets from its CDO at par, while the four other assets from two different CDOs were repurchased at an average discount to par of 46.3%, including one defaulted security that was repurchased at 0.001% of par.

The repurchases were likely prompted by an effort to maintain cushion in par value tests, thus avoiding the diversion of cashflow from the CDO's preference shares, Fitch notes. While only one repurchased asset was haircut in the prior month for purposes of its CDO's par value calculation, the remaining assets were expected to be haircut imminently based on their impaired statuses.

In most cases, new higher rated assets were traded into the CDO at a discount within a few days of the repurchases to rebuild the total CDO par. Fitch considers asset purchase prices in its evaluation of CDO collateral.

"Further maturity defaults are likely as the illiquid credit markets provide limited prospects for the payoff of loans," says Fitch senior director Karen Trebach. Excluding the repurchased assets, nearly all of the new additions to the CREL DI consist of matured balloon loans. Further, reported loan extensions decreased to 21 for the month, down from 37 in February, and more in line with the prior two months' totals.

Non-cash flowing property types comprise the highest percentage of assets in the CREL DI. Loans backed by interests in land are now the highest percentage of assets in the CREL DI at approximately 32%. Condominium conversions and construction loans comprise an additional 11.1%.

"Under the current credit market conditions, Fitch anticipates increased defaults on land loans as debt service reserves burn off and business plans fail to actualise," adds Trebach.

... while par value test is triggered
Realty Finance Corporation has received a written notice from the trustee of RFC CDO 2007-1 that on the 7 April 2009 payment date the transaction failed certain par value trigger tests that resulted in: (i) certain interest payments normally scheduled to the debt and equity holders of the CDO being allocated to the senior noteholders; and (ii) any available principal proceeds being allocated to the senior noteholders. Consequently, the company will not receive any cashflow distributions on the subordinated notes and equity investments that it owns in the transaction, or with respect to any subordinate collateral management fee, until such time - if ever - the par value tests are complied with.

Even if the par value tests are eventually complied with, the company's ability to obtain regular cashflows from the assets securing the CDO is dependent upon continuing to meet interest coverage and par value tests within the transaction. The failure of the par value tests was due to: (i) impairment of certain of the company's loans as a result of borrower defaults; and (ii) rating agency downgrades on certain of the underlying CMBS.

If the par value tests had not failed, the company would have received approximately US$487,000 in interest distributions and US$353,000 in subordinate collateral management fees for the 7 April payment date.

Significant growth recorded in derivatives collateral
Use of collateral in privately negotiated derivatives transactions grew significantly in 2008, with the amount of collateral in circulation now estimated at US$4trn, according to ISDA's 2009 ISDA Margin Survey. The results show an increase of almost 86% over the estimated US$2.1trn of collateral in the 2008 Survey. Cash continues to grow in importance among most firms and now stands at over 84% of collateral received and 83% of collateral delivered.

"Recent market events underscore the importance of collateralisation as a risk mitigation tool," comments Robert Pickel, executive director and ceo, ISDA. "ISDA's 2009 Margin Survey indicates that, amidst the volatility in the financial markets, collateral management programmes continue to expand, covering increased trade volumes and credit exposures."

The 2009 Survey reports that collateral agreements in place now number over 150,000. Among firms that responded both in 2008 and 2009, collateral agreements grew by 9%, with further growth of 26% forecast during 2009. This reflects a long-term trend toward increased collateral coverage, the Association says.

Additionally, more than half of the respondents stated that they engage in some form of systematic portfolio reconciliation, many on a daily basis. Of the 67 firms responding to the 2009 ISDA Margin Survey, 58 are banks or broker-dealers and the remainder are institutional investors and other end users.

Pool-specific performance data crucial to intrinsic value
S&P's Market, Credit & Risk Strategies group (MCRS) has released a report entitled 'The Highly Uncertain And Bipolar Outlook For UK Non-conforming RMBS'. The study concludes that significant attention must be paid to collateral pool-specific performance data for the deal being analysed as opposed to taking a broad-based asset class benchmark approach. Further complicating the challenge of establishing intrinsic value is that markets are always forward-looking, which means they don't price in current defaults and loss severity, but are discounting foreseeable trends in these and other key input criteria, the report notes.

"Logic suggests that mortgage delinquencies, as a barometer of homeowner distress, should be fairly indicative of future default rates," it explains. "Fortunately, or unfortunately depending on your perspective, this hasn't yet been the case. While a high correlation between delinquencies and defaults would be very helpful for predicting future CDRs (constant default rates), we should probably be thankful that the relationship falls far short of a 1:1 ratio."

This is because total UK non-conforming RMBS delinquencies are currently running as much as four times the magnitude of calculated defaults, according to the report. In the report MCRS analyses the wide gap that can exist between non-conforming collateral delinquencies and defaults, and then discusses the implications for RMBS valuation and the potential problems this presents policymakers in their efforts to counter the credit crunch.

Among the report's key findings are that current non-conforming UK RMBS default rates of 5% to 10% do not look all that threatening when viewed in a vacuum. However, total non-conforming UK mortgage delinquencies of 15% to 45% look downright scary. Indeed, while default trends may have recently stabilised, delinquencies have not - potentially foreshadowing deteriorating homeowner credit conditions.

The report urges UK policymakers to jump-start the housing market to stabilise home prices and arrest the worrisome trend in rising delinquencies in order to avoid the 'dark-day' scenario that is building in non-conforming RMBS, should delinquencies end up being predictive of future default rates (see SCI issue 130). If stabilisation efforts prove to be successful, then many of today's 'toxic' assets will turn out to be much less impaired than currently believed, the MCRS group concludes.

Parameter uncertainty explained
The BIS has released a working paper entitled 'Measuring portfolio credit risk correctly: why parameter uncertainty matters'. The report attempts to explain why risk management systems should account for parameter uncertainty.

In order to answer this question, the paper lets an investor in a credit portfolio face non-diversifiable estimation-driven uncertainty about two parameters: probability of default and asset-return correlation. Bayesian inference reveals that - for realistic assumptions about the portfolio's credit quality and the data underlying parameter estimates - this uncertainty substantially increases the tail risk perceived by the investor. Since incorporating parameter uncertainty in a measure of tail risk is computationally demanding, the paper also derives and analyses a closed-form approximation to such a measure.

The impact of parameter uncertainty on the VaR perceived by an investor in a homogeneous asymptotic credit portfolio is analysed. Indeed, the main conclusion of the study is that this impact is strong for a wide range of portfolio characteristics and for a wide range of dataset sizes.

Relaxing some of the assumptions adopted by this paper would provide for fruitful directions of future research, according to the BIS. One is to address rigorously the issue of parameter heterogeneity in the context of credit VaR measures. Given that deriving and simulating the joint posterior distribution of a large number of heterogeneous parameters is likely to impose an insurmountable computational burden, it is important to establish conditions under which it is justifiable to focus solely on noise in the estimator of a representative (e.g. the average) parameter.

Another possible direction of future research is to consider cyclical developments in credit conditions, which make credit-risk parameters change over time and, consequently, impair the estimates of these parameters.

Improvements noted in CDS spreads, loan prices
Through to 15 April 2009, year-to-date spreads as measured by S&P Index Services spreads show that higher quality entities, as represented by the S&P 100 CDS Index, have improved by 20% (see data). Additionally, investment grade entities (mostly triple-B rated in the S&P CDS US Investment Grade Index) have improved by 15%, while high yield entities (as represented by the S&P CDS US High Yield Index) have improved by 5% - a level not seen since 13 January.

At the same time, the S&P/LSTA Leveraged Loan 100 Index hit a new high for the year this week, registering a return of 18.76%. The weighted average bid price (based on outstanding amounts) also hit a high for the year at 71.17 - a 14.8% change for 2009. This is because limited new issuance and reinvestment of funds are driving prices in the most available loans higher, according to S&P.

Impact of valuation/leverage on procyclicality explored ...
The Committee on the Global Financial System (CGFS) has released a report, entitled 'The role of valuation and leverage in procyclicality', which sets out a menu of policy options that could be considered to mitigate these procyclical mechanisms. These include quantitative limits on leverage, steps to support better measurement and pricing of risk through the cycle (in particular funding liquidity risk), and measures to mitigate procyclical effects that mark-to-market valuation may have on incentives and decision-making.

Market practices related to market-sensitive valuation techniques appear to have contributed to an increase in the procyclicality of leverage in the financial system, the Committee notes. Its report consequently explores the link between leverage and valuation in light of the recent experience of market stress.

Prior to the crisis, traditional balance sheet measures of leverage did not give an unambiguous signal of higher risk during the boom years of 2003-2007. While balance sheet leverage increased at European banks and US investment banks, and for the household sector in many countries, there was not a widespread increase for other banks or the corporate sector.

Nevertheless, a break in the trend in leverage seems to have occurred around 2003-2004 as leverage and risk started to build up in less visible ways, and this set the stage for the crisis:

• the leverage and risk embedded in structured credit products increased, making traditional measures of balance sheet leverage less meaningful;
• assets held in highly leveraged off-balance sheet vehicles increased dramatically;
• maturity mismatches and exposure to funding liquidity risk increased as off-balance sheet vehicles and some large financial institutions funded a growing amount of long-term assets with short-term liabilities in wholesale markets.

Since the crisis broke in mid-2007, part of this build-up of leverage and risk has reversed, at times with disruptive consequences.

Over a longer time period and, as a result of a range of market and regulatory developments, fair value measurement has come to be more widely used for financial reporting purposes. At the same time, mark-to-market valuation techniques have become more widely used for risk management purposes.

Although it was not well understood during the boom, it has now become clear that these two developments - the increase in leverage and risk during 2003-2007 and the spread of market-sensitive valuation techniques - are related. While market practices related to market-sensitive valuation techniques have existed for some time, their growth appears to have created a risk to financial stability. In short, these market practices appear to have contributed to an increase in the procyclicality of leverage in the financial system, according to the CGFS.

The report discusses six market practices:

• Value-at-risk and other market-sensitive risk measures that did not capture 'through-the-cycle' volatility.
• Triggers in debt or OTC derivative contracts that reduce a firm's liquidity in times of stress when a trigger based on a market valuation or credit rating is breached.
• Strongly procyclical haircuts on financing transactions and initial margins on OTC derivatives, which have a similar effect of adding liquidity to the market in a boom and draining it in times of stress.
• Upfront recognition of profits on structured products where some risks were retained.
• Use of mark-to-market valuation practices even for assets where markets have become illiquid, thereby yielding valuations that seemed too low to some and highly uncertain to many, with adverse consequences for firms reporting such valuations.
• Carrying assets and their hedges at fair value as an alternative to hedge accounting.

Looking ahead, the procyclical effects arising from the interplay between leverage and valuation need to be assessed from a macro-prudential perspective, according to the report. "It appears desirable for regulators and supervisors to get a clear and comprehensive picture of aggregate leverage and liquidity and have the necessary tools to trigger enhanced surveillance if necessary."

Suitably constructed leverage ratios may, both as indicators of potential excesses and safeguards against amplification mechanisms, play a role in a macro-prudential framework. Equally, the proper pricing of funding liquidity risk in the system could be key in preventing a build-up of leverage and maturity mismatches in the future. Finally, valuation and risk measurement methodologies - while keeping as close as possible to market inputs and best practices - should also avoid creating incentives for excessive risk-taking through underestimating the price of risk.

... as Basel Committee releases final fair value guidance
The Basel Committee on Banking Supervision has released its final paper on supervisory guidance for assessing banks' financial instrument fair value practices. The paper provides guidance to banks and banking supervisors to strengthen valuation processes for financial instruments.

The principles promote strong governance processes around valuations; the use of reliable inputs and diverse information sources; the articulation and communication of valuation uncertainty to internal and external stakeholders; the allocation of sufficient banking and supervisory resources to the valuation process; independent verification and validation processes; consistency in valuation practices for risk management and reporting purposes, where possible; and strong supervisory oversight around bank valuation practices.

The application of fair value accounting to a wider range of financial instruments, together with experiences from the recent market turmoil, have emphasised the critical importance of robust risk management and control processes around fair value measurements, the Basel Committee states. Moreover, given the significance of fair value measurements for regulatory capital adequacy and internal bank risk management, it is equally important that supervisors assess the soundness of banks' valuation practices through the Pillar 2 supervisory review process under the Basel 2 framework.

Bank plans CLO buybacks
In the latest instance of issuers buying back structured finance debt (see last week's issue), HSBC has announced it is looking to repurchase CLO notes issued by Metrix Funding 1 and Metrix Securities, for cash. Both senior and junior notes will be purchased by the bank, which is buying back the notes to keep on its own books.

Metrix Funding closed in 2005 and is a cash balance sheet corporate CLO. Metrix Securities closed in 2006 and is a fully-funded synthetic balance sheet CLO, referencing a £2bn portfolio of sterling-, euro- and US dollar-denominated bank loans and undrawn facilities granted by HSBC Bank to corporate borrowers.

HSBC has provided minimum prices on each class: 84.5% for senior notes of Metrix Securities Series 2006-1 and 91% for senior notes of Metrix Funding 1. Mezzanine and subordinated tranche prices range from 74.25% down to 15% for the lowest E Classes of Metrix Securities 2006-1.

The deadline for accepting bids is 28 April. The bank could repurchase up to £500m of senior notes and £150m for junior notes, according to ABS analysts at SG.

Effect of loan rally on CLOs to be deal-specific
Based on the latest figures from Intex, the average lowest OC (BB/BBB) cushion is scarcely 0.9% among the 569 CLOs sampled in a recent JPMorgan analysis. Further, 39% of this sample has by now breached with a -2.96% deficiency on average, while there is only 3.4% of cushion left on average for those deals remaining above the threshold. Finally, the average triple-C bucket has reached 10.2%, significantly up from 7.1% at end-2008 and 4.1% in July 2008, according to structured credit analysts at JPMorgan.

"While it's difficult to generalise, we project a maximum of 25bp-50bp of OC improvement in the CLO market, in the context of the above figures and the rally in loan market prices since March," the analysts add. "It is a question of price change in the triple-C and defaulted security buckets, as well as the concentrations themselves, but in the current market it's doubtful April will bring enough OC improvement to cure the average failing transaction since the average failure is as much as 2.96%." Although some transactions that are on the edge of the threshold may benefit enough to bring OC ratios back into compliance, it will be transaction-specific.

Potential noted for double-counting in SF CDO capital charges
Fitch has issued a report that comments on recent Basel 2 proposals responding to the financial crisis. While the agency says the overall proposals provide meaningful enhancements that will further strengthen the effectiveness and rigour of the Basel 2 capital framework, its analysis indicates that specific aspects could have unintended effects on the risk-sensitivity of capital requirements for structured finance exposures. Fitch also sees potential overlap between its tightened SF CDO rating criteria and proposed increases in Basel 2 risk-weights on resecuritisation exposures held by banks, which could result in the 'double-counting' of risks within SF CDO capital charges.

Fitch recently developed revised rating criteria for SF CDOs that apply a rigorous and robust treatment of potential risk concentrations within these structures (SCI passim). As a result, the enhancement levels needed to achieve investment grade ratings have increased considerably, particularly for collateral pools characterised by risk concentrations and thinner tranches. However, as part of the proposed Basel 2 enhancements under Pillar 1, which addresses minimum regulatory capital requirements for banks, the risk weights for resecuritisations, such as SF CDOs, will be increased relative to the risk-weights on other forms of securitisation exposure.

"One of the main factors driving recent SF CDO credit deterioration has been risk concentrations within the underlying pool of structured finance collateral to the same asset classes, geographic areas and, importantly, vintages, since assets originated within the same time period are exposed to similar underwriting risk factors," says John Olert, group md, Fitch structured finance group. "With both Fitch tightening its SF CDO rating criteria and Basel 2 increasing the associated capital charges on resecuritisations, it appears that there is a potential overlap in these efforts especially if other agencies make similar changes to their criteria."

"In concept, similar risk exposures should face similar capital charges, irrespective of the form that the exposure takes. When layering the higher proposed Basel 2 resecuritisation charges onto the additional conservatism of Fitch's SF CDO criteria, our analysis indicates that the Basel 2 capital charges on the full SF CDO capital structure could be several multiples higher than the Basel 2 charges on the entire underlying pool of structured finance collateral - even though the risk exposure is essentially the same," adds Ian Linnell, group md, Fitch structured finance group.

Negative outlook for global RMBS
Fitch says the outlook for the global residential market and RMBS ratings remains negative in 2009 as loan defaults are expected to increase while prepayments will slow considerably. Downgrades will continue to significantly outweigh upgrades in 2009 across all rating categories. However, Fitch anticipates that, other than the US, the majority of rating actions for RMBS will be confined to lower-rated tranches and that highly rated tranches are able to weather the current downturn.

For a second consecutive year, global RMBS experienced net negative ratings performance in 2008, with an upgrade-to downgrade ratio of 0.01 to one. Global RMBS rating statistics are dominated by the US, due to its size and maturity, representing 91% of the 2008 cohort. Furthermore, rating activity has been more pronounced in the US than any other market due to the speed and extent of the deterioration in the US housing sector.

"The 2008 transition statistics are heavily influenced by the more recent vintage years, 2006 and 2007 in particular," says Rodney Pelletier, head of EMEA structured finance performance analytics at Fitch. "In 2008, 15.1% of all triple-As were downgraded. However, this negative rating migration statistic drops to 3.9% if both the 2006 and 2007 vintages are excluded."

Global RMBS bond impairments increased significantly in 2008 to a total of 5988, a record high - more than an eight-fold increase over 2007's level, which witnessed 734 impairments. The annual impairment rate recorded its highest level at 24.3%, up from a low 3.7% the previous year. Observations were dominated by the US, with European RMBS accounting for less than 1% (56) impairments.

"The increase in impairments reflected weak housing markets in most countries - particularly in the US - with the industry characterised by house price declines, falling transaction volumes, low consumer confidence and restricted lending," says Charlotte Eady, associate director in Fitch's performance analytics team.

ABSXchange enhanced
S&P's structured finance platform ABSXchange has released a series of enhancements to its loan-level stress-testing capabilities and portfolio analytics, together with improving the reporting features on CMBS transactions. Cashflow models for many UK master trusts, European CLOs and Australian RMBS are also being added, while an additional asset class (credit card ABS) has been introduced to the Rating Review Triggers service. The user interface, meanwhile, has been improved to align better with users' work flows and new add-ins now allow users to export data to more external applications.

ABSXchange allows users, including European ABS portfolio managers, risk managers, traders, researchers, credit analysts and market regulators, to analyse performance data from across the universe of publicly rated, securitised credits to project deal cashflows and to monitor their portfolios.

David Pagliaro, EMEA commercial director of ABSXchange, comments: "This new version of ABSXchange includes a series of upgrades that will allow users to perform more rigorous examinations of structured finance transactions. The new portfolio analytics features are more closely aligned with user work flows and we have introduced a scalable format for future portfolio management services to be added, such as CLO portfolio analysis and valuation services."

French car scheme to have neutral impact on auto ABS
Fitch says that the French government's auto scrapping incentive will have a neutral impact on residual auto values and ultimately on French auto ABS transactions. "Although the scheme will have a neutral impact on French auto ABS transactions, it could potentially provide some dynamism to the auto industry," says Natalia Bourin, senior director, Fitch's French structured finance team.

The French scheme allows individuals to receive a government subsidy towards the purchase of a new, more fuel-efficient car if they scrap their old vehicle. Subsidies, starting at €200 and rising to €5000, are tied to a car's CO2 emissions, whereby a higher subsidy is allotted to more fuel-efficient cars. An additional subsidy of €1000 is available for cars aged 10 years or older that are scrapped against the purchase of a new car that emits less than 160g of CO2 per kilometre.

The scheme runs until the end of 2009. However, Fitch believes it will mainly result in new vehicle purchases being shifted forward in time and is unlikely to contribute to increased future volumes in the used car segment.

"The scheme mainly stimulates individuals who would have bought a new car anyway, although at a later stage," says Emmanuelle Ricordeau, senior director, Fitch's French structured finance team. "The scheme does not typically provide sufficient economic incentive for the used car customer to shift to the new car segment and pay the additional premium that new cars have over used vehicles. As a consequence, no large arrival of vehicles in the used car market is expected and the impact of the scheme on residual values is expected to be negligible."

TARP money to be returned 'only if in national interest'
It is likely that healthy US banks keen to return government funds will be allowed to do so, but only if certain conditions are met. The aim is for such repayment to be in the national economic interest, according to Credit strategists at BNP Paribas.

The strategists suggest that before allowing banks to pay any TARP money back, the US government will look at the stress test results (due to be announced in early May) to ensure that: (1) the financial system is stable; (2) the repayment does not create incentives for further deleveraging that would deepen the recession; and (3) the system is adequately capitalised to provide credit to support the recovery. "The return of funds, subject to the conditions above, should benefit the economy in two ways: firstly, it will make more money available to the government to support more needy institutions and, secondly, it will allow healthier institutions to differentiate themselves from weaker entities," they note.

Sovereign CDS data pack released
CMA has released the DataVision sovereign CDS data pack, which offers same-day price verification data for CDS referencing international government and US state debt, as well as extensive risk and liquidity metrics and implied ratings. Pricing is sourced from DataVision's buy-side consensus-based model.

The release follows high demand for independent CDS pricing data on sovereign names from traders, central banks and risk managers as levels of government debt have risen as a result of stimulus measures taken on by governments around the world. The package will enable effective risk management of government bond exposures, accurate daily valuations of sovereign CDS positions as well as informing FX trading strategies.

Laurent Paulhac, CMA's chief executive, comments: "Sovereign CDS levels have come into increasing focus in recent months as government-driven rescue packages have transferred risk from the corporate to the state level. We have noticed demand from firms who are non-traditional credit market players expressing a need for accurate price information on sovereign entities, so it made sense to offer a new data package which enables clients to effectively monitor the risks associated with their sovereign debt and currency exposures in a cost-effective way."

CS & AC

Trading

Modelling default risk in government-guaranteed bonds

Sandrine Ungari and Julien Turc, quantitative strategists at SG, find that government-guaranteed bonds issued by Lloyds and Barclays are expensive versus model, while some German issues are cheap versus model

In October last year, governments rolled out bailout plans for banks, including measures to help them raise funds in the market. Under these measures, banks can issue debt guaranteed by the state: this marks the launch of a brand new asset class in the bond market and provides investors with new relative value opportunities.

The wave of government-guaranteed issuance began with UK banks, such as Barclays, Lloyds and HBOS, and continued rapidly with other European and American banks. A substantial total of €231bn in government-guaranteed bonds has been issued to date, €134bn of which are guaranteed by eurozone governments.

The guaranteed bonds pricing model
Government-guaranteed bonds are fairly complex products, as they depend on both government and issuer credit risk. We will quantify default risk by using the concept of default probability. This measures the risk of an issuer defaulting on its debt at a given horizon.

It is very difficult to use history to estimate default probability, especially in the case of sovereigns, which rarely default on debt payments. We therefore prefer to use market prices to calculate implied default probabilities. We will then look at how to measure the risk associated with the issuing counterparty, before combining the two in order to price government-guaranteed bonds.

Modelling sovereign default risk
Any pricing function depends first and foremost on a 'risk-free' interest rate curve. Before the current crisis, sovereigns' credit risk was relatively low and government bond yields could be used as this 'risk-free' reference.

In the eurozone, for example, German yields would have been a valid reference and other curves would have been defined relative to the German curve. However, it is no longer possible to make this assumption in the current environment.

Sovereign CDS spreads have reached previously unheard of levels. This means that two different components are now embedded in sovereigns' yield curves: the pure 'risk-free' interest rate component and the credit risk component, i.e. the premium paid to the investor for supporting government default risk.

In order to price government-guaranteed bonds, it is important to find the correct interest rate reference. In the simple case where only one government issues in a particular domestic currency, the adjusted risk-free curve is obtained directly. For the euro, however, there are differences between different government bond curves, and we need to do some averaging out.

Using CDS as proxy for default risk
We will use CDS prices to estimate sovereign default probability. From a pure pricing perspective, CDS levels depend on three different factors: the recovery assumption, the discount factor used to calculate the present value of cashflows - calculated from the rate curve - and the probability of issuer default.

Estimating recovery rates
By definition, recovery is the percentage of face value and/or coupon which is recuperated incase of default. Estimating a recovery assumption for sovereigns is tricky, as default events are rare - and almost unheard of among European countries.

We have looked at a study published by Moody's in April 2006, 'Default and Recovery Rates of Sovereign Bond Issuers, 1983 - 2005'. The sovereign recovery rate was found to be 40%. We will use this as our recovery assumption for sovereign debt instruments in the rest of this document.

Calculating sovereign default probability
Standard government bond yields depend on 'risk-free' interest rates and the default risk of the sovereign concerned. Given that the default probability is calculated from CDS prices, we can now use bond prices to estimate the risk-free rate.

Step 1: From CDS and matching bond prices to estimated default probability and risk-free rate
For all pairs consisting of a sovereign bond and a CDS of equivalent maturity, we estimate the implied risk-free rate and sovereign default probability. These are calculated so that the model prices of the CDS and the bond match their market prices.

For clarity's sake, we will use the example of the French OAT October 2012. At the time of writing, the asset swap spread for this bond is -8bp and the 3-year CDS spread is 75bp. These prices imply a risk-free rate of 1.5% and a default probability of 1.2%.

We carried out the same exercise with all sovereign bonds issued in the eurozone by France, Germany, the Netherlands, Portugal, Spain, Austria, Belgium and Ireland, plus bonds issued by Denmark, the UK and the US. At the time of writing, these are the only countries which have issued government-guaranteed bonds.

Step 2: Averaging the risk-free curve
The previous step has provided us with as many risk-free rates as bonds issued by governments. The two graphs in Exhibit 1 show the results: each point on the graphs corresponds to a risk-free rate obtained from a given instrument. At this stage, it is important to distinguish between eurozone and non-eurozone countries.

Exhibit 1 - Source: SG

We postulate that only one risk-free curve can exist for the eurozone, so we need to find an average risk-free curve which explains as many data points as possible. The resulting curve is the pink line in the left-hand graph. As expected, it is consistently below the curve fitted on swap rates.

Single-country risk-free curves are much more consistent. The main difficulty is interpolating rather than finding an optimal curve. Results are given in the right-hand graph.

To return to our example, the average risk-free curve is calculated from all the European bonds in our dataset. For the French OAT October 2012, this corresponds to an average rate of 1.4% - which is different from the risk-free rate implied from the price of this specific bond and its associated CDS.

To average out and/or interpolate the risk-free curve, we use a parametric model proposing an analytical formula for the risk-free rate. In such a model - the classical Vasicek interest rate model - the risk-free rate depends on four parameters: the current value, the long-term reversion level, the mean reversion speed and volatility.

Step 3: Estimating sovereign default probability from CDS prices, given the calibrated risk-free rate
The average risk-free rate differs from that implied by the price of a specific bond and its associated CDS. So, using the average risk-free rate, we can re-compute the default probability implied from the CDS price. Using this method, the French OAT October 2012 has a default probability of 1.18% (versus 1.2% using the bond and CDS prices).

Exhibit 2 summarises the results for all the sovereigns we look at in this study. As expected, the least risky eurozone countries are Germany, France and the Netherlands, with Portugal and Ireland the most risky. The US is similar to the less risky European countries, while Denmark and the UK are more similar to Spain or Portugal.

Exhibit 2 - Source: SG

The calibrated risk-free rate is always less than the corresponding swap rate. The widest spreads are found in the UK and Denmark. The eurozone spread is the smallest.

Modelling issuer default risk
In the preceding section, we explained how to estimate the default risk of a sovereign within or outside the European monetary union. We now concentrate on the second part of our modelling task: estimating the risk on an issuer of government-guaranteed bonds. There are two different forms of government-guaranteed bank debt issue:

• the standard set-up, where the bank issues the bond with a guarantee from the government;
• and the French case, where the bond is issued by a specially created company, the Société de Financement de l'Economie Française (SFEF) and the money is lent to an anonymous pool of banks. In this case, SFEF default probability is calculated as the joint default probability of all borrowers and the government.

Standard case
The default probability of a financial issuer can be estimated using either CDS prices or bond prices. As our final goal is to price a bond, we choose to use use bond prices. This will save us from having to estimate the basis between bond and CDS prices.

For each guaranteed bond, we find a senior unsecured bond of equivalent maturity issued in euros by the same company. The reference interest rate curve we use for discounting is our risk-free curve for the euro.

Recovery is again a central assumption here. For senior unsecured bonds, we have assumed a recovery rate of 60%, which is the standard assumption in the credit market for such bonds.

Exhibit 3 shows the results we obtain for the pool of issuers in our study. NIBC Bank and LeasePlan have the highest default probabilities, while German banks and some of the Danish banks have the lowest ones.

Exhibit 3 - Source: SG

Treatment of joint default risk
The third part of our modelling task consists of estimating joint default risk. This is the probability of a simultaneous default of an issuing bank and the government backing the issue.

This calculation depends on what we assume to be the correlation between a bank and a government default. We estimate this correlation as the statistical correlation between CDS prices over a year, measured weekly (see Exhibit 4).

Exhibit 4 - Source: SG

Analysing market prices: what value in government-guaranteed bonds?
We now concentrate on the pricing of government-guaranteed bonds themselves and introduce three possible approaches:

• The simplest model consists of pricing the bond directly, with no further assumptions concerning the liquidity premium or potential additional risks linked to the nature of the guarantee. We will show that this approach leads to a blatant mispricing of the guaranteed bonds: the model asset swap spreads we obtain are systematically smaller/more negative than the corresponding market asset swap spreads. This highlights the need to build assumptions into our model;
• We then look at an improved version of our original model. It is designed to fit the market on average and is what we would call a market model. We introduce a premium to price the liquidity of government-guaranteed bonds. This liquidity premium is estimated on a country-by-country basis, and we find significant differences between countries.
• A third section proposes an explanation for this difference in liquidity risk premia. We introduce a certain level of risk on the guarantee itself. The relative cheapness of certain bonds can be explained by fears that the guarantor might not fully apply the guarantee. This translates into a potential loss for the investor if the guarantee is applied. We will show that this risk remains relatively small for all the guaranteed bonds in our study.

Government-guaranteed bonds are cheap versus model...
We use the building blocks from the first part of this document to price government-guaranteed bonds. These building blocks allow us to calculate the bonds' discounted cashflows and to weight them according to the relevant probabilities.

Four different scenarios are possible:

• Both government and bank survive: the ideal case - no losses for the investor, coupon and final reimbursement are paid in due time;
• Both government and bank default. In this case, the amount recovered by the investor is linked to the seniority of the bond and will come from the restructuring of bank debt. In the present paper, we consider senior unsecured securities only, and we therefore take the standard 60% assumption for the recovery rate;
• Government defaults and bank survives. This has no implications from the bondholder's point of view. In the special case of the SFEF, however, this case is excluded: the SFEF would default would only default if and when all the banks in the pool defaulted.
• Government survives and bank defaults. This is the case where the government guarantee should apply. In theory, the investor is protected against a bank default and should be repaid any accrued payment and the notional. However, in practice we might wonder if the government would fully honour the guarantee in an extreme situation (later we will see that any residual risk included in market prices may be partly explained by assuming that there may after all be some losses in cases where the guarantee is called on).

The scenario analysis shows that the holder of a government-guaranteed bond can suffer a loss in only one case - if both bank and government fail at the same time. In all other cases, either the government guarantee is called into play, or the bank survives and pays its debts back. This means that government-guaranteed bonds are more secure than any government bonds and should be more expensive than sovereigns.

However, this is not the case in practice, as illustrated by Exhibit 5: assuming that a loss occurs only when both entities default and that no liquidity premium is included in the bond price, the government-guaranteed bonds in our sample are cheap versus model (the bold grey line shows fair value). So the question is now: why do market participants systematically underprice guaranteed bonds? The first and immediate answer is that they price in a big liquidity premium.

Exhibit 5 - Source: SG

... unless a liquidity premium is included in the market price
Thanks to their embedded state guarantee, an investor could buy government-guaranteed bonds as sovereign issuance and benefit from the spread pickup. However, this is done at the cost of liquidity: the buying of a less liquid asset rather than an equivalent highly liquid one is rewarded with a liquidity premium. The more significant the difference in liquidity, the larger the liquidity premium will be.

For each government-guaranteed bond, we calculate the liquidity premium such that the model price is the same as the market price. We then average it out on a country-by-country basis. The liquidity premium accounts for about 90/100bp of the asset swap spread value.

Exhibit 6 summarises the results, which divide government-guaranteed issuance into three groups:

• a low liquidity premium group, including issuance guaranteed by some peripheral countries such as Denmark and Austria;
• a medium liquidity premium group, including bonds guaranteed by Ireland, Portugal, Spain, the Netherlands, Germany and France; and
• a high liquidity premium group, including UK- and US-guaranteed issues.

We use the average liquidity premium to re-compute the bond fair value given by our model.

Exhibit 6 - Source: SG

The inclusion of the liquidity premium allows us to estimate the fair value of government-guaranteed bonds. We can distinguish between two types of government-guaranteed bonds:

• Government-guaranteed bonds that are expensive versus model: Lloyds and Barclays issues, Austrian KA bonds and SFEF-guaranteed bonds;
• Government-guaranteed bonds that are cheap versus model: some German issues, BOS and Dexia issuance.

...or the guarantee is fallible
Alternatively, we could see market mispricing as reflecting that market participants might not entirely trust the government guarantee and are being paid a premium for potential losses in cases where the guarantee is applied. In Exhibit 5, this would correspond to a non-zero loss rate in the case where a bank defaults and the government survives. Our model allows us to estimate the loss rate implied by market prices when the guarantee comes into play.

First, we will assume no liquidity premium, and we calibrate the loss rate associated with the guarantee on a country-by-country basis. Then we will include the liquidity premium and recalculate the loss rate associated with the guarantee.

For our first calculation, we assume no liquidity premium and we calculate the loss rate for each guaranteed bond such that market and model prices are the same. We then average out this liquidity premium on a country-by-country basis (Exhibit 7).

Exhibit 7 - Source: SG

The model must attribute a high loss rate to SFEF bonds in order to explain market prices. Using this approach, bonds backed by Germany and the US would also see a high loss rate linked to use of the guarantee. Given the security offered by the SFEF, this result is odd and illustrates the necessity of taking a liquidity premium into account.

We now apply a liquidity premium to each guaranteed bond, as explained above (Exhibit 8). The results show that even taking this liquidity premium into account, the market still sees some guarantees as risky.

Exhibit 8 - Source: SG

Our model estimates that an investor has a residual risk of not recovering all its investment on bonds guaranteed by the governments of five countries. Ireland and Austria are the two countries with the highest loss rate when the guarantee is applied, while the US, Portugal and the UK have lower - but not zero - loss rates.

© 2009 Societe Generale Cross Asset Research. All rights reserved. This Research Note is an excerpt from 'Modelling default risk in Government-guaranteed bonds', first published by Societe Generale on 14 April 2009.

Trading

Trading ideas: tight tech

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

We continue to find opportunities in the tech sector this week. CA Inc's CDS now trades at levels not seen in over a year and yet its equity trades lower than mid-February levels.

Our CSA model finds a major disconnect between CA equity, vol and CDS, and our directional credit model points to significant deterioration as well. Rather than taking an outright short credit position, we recommend buying CDS protection and selling equity puts to hedge against further credit improvement and gain from a return to fair value.

Delving into the data
Exhibit 1 charts CA's market and fair CDS levels over the past few months. CA now trades at levels not seen since January 2008. With CDS too tight compared to equity, we expect a combination of equity rally, drop in vol and CDS widening. Our directional credit model indicates widening of CA CDS based on market vol and accruals rankings.

Since we expect a modest stock rally and a drop in implied vol, we recommend selling at-the-money puts on CA to go long delta and short vol. We are betting that one of two outcomes will occur.

First, if CA's CDS deteriorates as expected, the profit from our short credit position will outweigh the loss from our short put position. Second, if CA improves rather than deteriorates, we expect equity and vol to far outperform CDS.

If CA CDS tightens by more than 20bp, we will lose money on the trade since our equity leg upside is limited to the put premium. With CA trading so tight compared to recent history and our directional credit model pointing to a CDS sell-off, we like having the payoff skewed towards credit deterioration.

Exhibit 1

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

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

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

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

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

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

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

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

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

Buy US$10m notional CA Inc 5-Year CDS at 100bp.

Sell 560 lots CA Inc US$17.50 strike Aug 09 puts at US$195/lot.

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).