Contents

Secondary markets

Liquidity rising?

Secondary CDO activity buoyant, in spite of downgrade threat

The recent rally in CLOs and in credit more broadly has supported the burgeoning liquidity in the CDO secondary market, with BWIC activity accounting for around US$1.6bn in June so far. However, the threat of mass downgrades is still weighing on the sector.

"Certainly we've seen increased liquidity in the CDO marketplace over the past two months, albeit last week activity slowed down a bit because too much supply hit the market. Liquidity has been driven by the rally in the credit market more broadly, as well as by increased transparency," says Sal Cincinelli, CDO market specialist at SecondMarket.

He reports that listings on the SecondMarket platform have increased dramatically over the last few weeks, with activity focused on CLOs and TRUP CDOs. "Initially, trading was predominantly at the triple-A level but, as the CLO market rallied, liquidity flowed down the capital structure to single-As. Although most tranches are trading at distressed levels, triple-A prices recently jumped to the 80c region from the 60c region."

Structured credit analysts at JPMorgan note that demand is even strengthening for weaker double-A CLO tranches as investors look for bigger yields."In further evidence that the hunt for yield is broadening, [last] week we observed a strengthening in demand for weaker double-As with less advantageous event of default language; trading levels were in the US$40s to US$50s, depending on the transaction," they note. Single-A prices remain at around US$30, triple-Bs at US$12 and double-Bs at US$5, according to JPMorgan figures.

Sellers are typically those that bought paper through the SIV and market value CLO liquidations of last year, but who now want to take profits. Buyers, on the other hand, comprise some bank prop desks but are predominantly investors with the ability to drill down into the documentation and make their own recovery assumptions.

The SecondMarket platform has witnessed a wide range of bids and offers, reflecting the fact that each participant has their own opinion about what a deal is worth. According to Cincinelli, two factors are affecting CLO bid/offer spreads: event of default documentation and triple-C haircut provisions. At the double-A level, there is price differentiation between PIKable and non-PIKable tranches, depending on the vintage.

Prices are in the 20c-30c range for PIKable double-A tranches and in the 50c-60c range for non-PIKable double-A paper. "In non-PIK structures it is easier for senior noteholders to take control of the deal, as non-payment of interest constitutes an event of default," he explains.

In a recent special report Fitch warns that for CLOs any potential haircuts and treatment of PIK assets will remain transaction-specific and so investors should read the CLO documentation carefully. "For transactions that have the ability to invest in subordinated debt, if the PIK loan refers to a performing issuer (an IDR of single-B minus or above), the PIK can be held at par for the purpose of calculating O/C tests," the agency explains. "A haircut may apply for obligors rated triple-C and below or, otherwise, the PIK loan should be reflected at market value similarly to any other triple-C rated assets in the portfolio."

Similarly, European CLOs are bid lower than US CLOs because the underlying market is less liquid and less transparent. Trustee reports usually contain less information as the transactions are based on shadow ratings (as opposed to public ratings in US deals) and collateral pools have higher concentration limits. "The other factor impacting European spreads is the different bankruptcy regimes across the region, which means that recovery rates in Europe may vary significantly from those expected for US deals," notes Adrian Radulescu, head of the CDO desk at SecondMarket.

Meanwhile, the platform is seeing more interest in insurance TRUP CDOs than those backed by bank TRUPs. "Bank TRUPs vary in terms of quality - some banks are in better shape than others and some still have significant exposure to the mortgage sector - but insurance companies have typically fared better than banks through the crisis," continues Radulescu. "Nonetheless, TRUP CDOs are more specialised and less liquid than CLOs, with the trustee reports also being typically less transparent than those for CLOs."

The sectors yet to see much activity on the SecondMarket platform are CRE CDOs and CSOs, although Cincinelli says he has been in discussions with a number of sellers of risk. "Some holders in this situation probably weren't too familiar with what they were buying, which is now worth considerably less, while buyers today are more sophisticated. Additionally, CSOs are drastically different from each other in terms of customisation, which serves to reduce liquidity in the sector. Counterparty risk has proved to be problematic too," he adds.

Some investors are, however, said to be reconsidering their CSO restructuring options in light of tight spreads relative to recent history and signs that the market may no longer be in rally mode. Credit derivatives strategists at Barclays Capital have analysed four novel ways of approaching such restructurings, tailored to fit the investor's view of magnitude and timing of defaults. These alternatives include: unwinding part of the CDO and using the proceeds to add subordination on the remaining investment; selling the principal-only part of the CDO and using the proceeds to increase the interest-only coupon; selling the IO part of the CDO and using the proceeds to increase the subordination of the PO; and selling the CDO and using the proceeds to buy iTraxx IOs or POs.

Looking ahead, Radulescu expects a wave of CLO downgrades to hit the market in the coming weeks, as Moody's implements its ratings review across the sector. He concludes: "Currently we have significant discrepancies in transaction ratings. With high grade CLO paper (triple-A and double-A) expected to be impacted, the regulatory capital implications could create another wave of forced selling from bank balance sheets this time. It will be interesting to see how this pans out."

CS

Structuring/Primary market

Dynamic disintermediation

Unprecedented actions necessary to break CMBS stalemate

Actions taken by individual Extended Stay America noteholders last week shocked the CMBS industry. However, it has been suggested that such disintermediation moves are necessary to break the current stalemate between investors and service providers on failing transactions.

A group of investors in Extended Stay America's US$4.1bn CMBS (reportedly representing 25% of all noteholders) has partnered with the debtor to produce a 'term sheet' reorganisation plan, following the firm's bankruptcy filing last week. According to Moody's svp Daniel Rubock, the unprecedented disintermediation of the trust structure by individual noteholders directly pitching their economic interests to a bankruptcy court could have unknown consequences, if imitated in other distressed securitised transactions. "However, it is too early to tell if ESH is a harbinger, or just a fluke," he says.

The proposed plan throws out the cash waterfall and procedures of the deal's Trust and Servicing Agreement (TSA). Instead, the group urged the court to create a new US$1.8bn first mortgage benefiting only the top three certificate classes, a second mortgage for the next class and an equity-for-debt swap for just some of the remaining classes.

The ad hoc group did not consult the trustee or the servicer. Provisions in TSAs prohibit noteholders from solo appearances in court or otherwise to the prejudice of other noteholders, unless specifically authorised under very limited procedures. Noteholders excluded from the Extended Stay ad hoc group (including Bank of America and Five Mile Capital) are understood to have filed vigorous emergency objections to the unauthorised debtor-noteholder joint venture.

Not only did the term sheet plan largely jettison the TSA, but it also advocated indemnifying David Lichtenstein of Lightstone Capital up to US$100m for violating the recourse guarantees he gave the lenders at loan closing. Additionally, the ad hoc group urged that US$5m in cash collateral be reserved to cover the legal fees Lichenstein may incur defending his actions breaching the guarantee.

"The manoeuvring in ESH shows that while bankruptcy generally is not a good thing for a trust as a whole, it may be so for select members of the capital stack," Rubock notes. "If individual certificateholders can plead their cases, ignoring operative documents and bypassing the negotiated filtering mechanism of the trustee and servicers, structured finance may every so often turn into free-for-all finance. Preliminary indications are that the bankruptcy judge understands these implications, but we will be following this case closely for developments."

However, Mike Culhane, ceo of Oakwood Global Finance, argues that the stalemate between CMBS investors and service providers will only be resolved if some transactions break down completely and/or litigation ensues, otherwise economic value in the deals will continue to be lost. "But this isn't an easy pill to swallow. It'll be interesting to see whether certain managers will start buying swathes of notes to take control of transactions and break them down to their constituent parts."

There are several levels of frustration for investors in CMBS at present, according to Culhane. "Trustees are at the centre of the debate because they feel they can't do anything due to the different expectations of the senior and junior noteholders, while the existing commercial servicers are petrified about litigation and are therefore uncomfortable about answering even the most basic questions about collateral performance," he explains.

The majority of outstanding CMBS deals are due to mature over the next 1-5 years, which - given that they are highly levered bullet structures - represent a significant refinancing risk. Culhane reckons that every single such deal will have to be restructured in some way to mitigate this risk.

The latest European CMBS to be restructured - Windermere VII - has also been the subject of some controversy over the past week. The restructuring involved extending the maturities of the €50m Phoenix and €101m Firefly loans to April 2014 (original maturities were July 2010 and January 2011 respectively, assuming the one-year extension option is exercised in both cases).

According to Hans Vrensen, head of European securitisation research at Barclays Capital, the servicer's decision to extend the loan maturities and the current resolution proposal highlight the assertiveness of some private equity borrowers. "We recommend and expect senior CMBS investors to not vote in favour of the resolution and to contact the servicer for clarification on the maturity extension. If investors do not act now, a dangerous precedent could be set that could invite similar proposals and action from sponsors and servicers across many other CMBS deals."

He notes that the extensions are quite generous and might limit the servicer's ability to negotiate (on behalf of the bondholders) with the borrowers in future. "The key question is why such a long extension was needed at this point," he adds.

The borrower is affiliated with private equity fund manager JER Partners, with security comprising portfolios of German multifamily housing, which were allocated significant capex facilities under the original loans. "It seems that the borrower might not be as keen to invest in the portfolio, which was its business plan at loan origination, than to sell the units during the loan term. This is also clear from another notice posted last week calling for bondholder approval of a resolution to release the funds in the capex accounts, which have been stuck as a result of the Lehman Brothers administration," Vrensen continues.

The sponsor's proposal also asks for a release of its original obligation of 15% equity co-funding for the capex in return for a cash trap. Given the uncertain coverage on the loan, it is unclear if a cash trap will be effective in the short term.

Other European CMBS that have recently breached, or are close to breaching, their financial covenants include White Tower 06-3, Eclipse 06-4 (Hercules) and Windermere IX (see News Round-up).

CS

Documentation

Sticking point

Optionality issues remain as Euro CDS standards applied

Changes to the trading convention for European CDS took effect on Monday, 22 June, including the adoption of fixed coupons payable up-front (SCI passim). The move went smoothly; however, issues over 'optionality' in restructuring as a credit event remain.

The transition to standardised European CDS contracts ran fairly smoothly, according to Jeff Kushner, ceo of Blue Mountain Europe. "It seems to have gone fine," he confirms. "However, it was a slow June week generally, so we'll have to see how it goes. There is still some uncertainty over which coupons are likely to be the most liquid ones."

Europe has opted for four standardised coupons - 25bp, 100bp, 500bp and 1000bp - with two additional coupons of 300bp and 750bp for the re-couponing of legacy CDS. "Some sell-side traders have opted to use the 300bp strike as a liquid coupon, which has also added some confusion," says Kushner. "However, I expect most buy-siders to choose 500bp and 100bp as the most liquid points."

He adds: "Long term, I expect the new contracts to encourage those that have not used CDS in the past to come into this space. Simpler CDS contracts should lead to greater transparency and liquidity."

Meanwhile, the industry is still finalising details on the settlement of CDS that incorporate restructuring as a credit event, with the issue of 'optionality' proving to be a sticking point. Once restructuring credit event auctions are hardwired into CDS documentation, the contracts cannot be triggered after the auction was carried out and not later than 60 days after the determination date. This leads to a natural timing for future restructuring event auctions: 60 days after the determination date.

However, triggering a restructuring credit event is optional at present. This creates difficulties for prospective CDS central counterparties, which consequently must anticipate that some contracts for which a restructuring credit event has been determined will be triggered and others not. In this case a mechanism must be agreed upon by the clearing members to selectively trigger CDS.

This would involve balancing the books of the respective CCP on a daily basis, according to UniCredit senior credit strategist Tim Brunne. "For iTraxx CDS, the selective triggering of the contracts in case of a restructuring event could in principle yield two indices of the same series that need to be traded liquidly after the credit event occurred," he notes. "If several iTraxx constituents restructured their debt in a sequence, on each occasion the number of iTraxx contracts would double. Such proliferation is clearly undesirable."

Brunne suggests that splitting the iTraxx CDS into an index CDS on a new version of the iTraxx, with the respective constituent removed and a single name CDS that may then be optionally triggered is a simple and promising proposal. This option requires an amendment to the iTraxx CDS term sheet, but would also potentially entail difficulties for the tranche market.

However, whether optional triggering of CDS for which the occurrence of a restructuring credit event has been determined should be possible at all or should at least be restricted in some specific cases has been an open issue. Under certain circumstances, if for example the majority of the market triggers the CDS contracts, a credit event settlement of all outstanding CDS could be mandatory. This mechanism is referred to as 'collective triggering'.

"During the first two weeks of June, discussions among dealers and buy-side firms on the exact terms of collective triggering were still ongoing," confirms Brunne. "Obviously, a compulsory collective triggering would solve the index triggering problem. But a solution is sought that gains market-wide acceptance."

Whatever the solution to the optionality issue, the new terms will be implemented via ISDA's 'small bang' protocol and are anticipated to be implemented on 27 July.

Separately, in connection with trades for Latin America and emerging European CDS, end-users also switched from monthly to quarterly contract roll dates on 22 June. The move represents a step towards further standardisation and enhanced liquidity in emerging markets, according to ISDA.

"The adoption of fixed coupons in Europe and standardised quarterly roll dates in emerging markets demonstrate ISDA's and the industry's continued efforts to enhance liquidity, transparency and operational efficiency in the privately negotiated derivatives business," Robert Pickel, executive director and ceo of ISDA, remarks. "These changes are a major step in the standardisation and simplification of CDS that will benefit the robustness of the product."

AC

Regulation

Aligning incentives

Securitisation reform proposals discussed

The Obama administration's financial reform proposal is expected to have a wide-reaching impact on the securitisation market. Initiatives to align economic incentives among market participants and to achieve greater risk transparency have been broadly welcomed, however.

"We are encouraged by the focus on securitisation in Treasury's plan, as it reflects the importance of restoring confidence and function to this critically important segment of the capital markets," comments George Miller, American Securitization Forum (ASF) executive director. "The industry pledges to continue to work closely with the administration and global policymakers on this vital topic."

As part of the move towards strengthening the supervision and regulation of securitisation markets, the reform proposal confirmed that originators or sponsors will be required to retain 5% of the credit risk of securitised exposures (see last week's issue). But this model is reliant on the economics of the transaction working efficiently, according to Mike Culhane, ceo of Oakwood Global Finance.

"In the current environment the economics will only work if consumers pay higher margins," he says.

Culhane concedes that the prospect of margin hikes comes at an unfortunate time for consumers and, because only some consumers will be willing to pay higher margins, new issue securitisation volumes will remain limited in the near future. He points out that in any case the market is implying it wants 8% of the risk to be retained by originators/sponsors.

As investors become more comfortable with transactions, the percentage retained by originators will likely decrease and the benefit could be passed onto the consumer. Conversely, if less than 5% is required by the market and the government still mandates that number to be retained, the consumer will be disadvantaged.

The regulations will also seek to prohibit originators from directly or indirectly hedging or otherwise transferring the risk of the retained piece. This is critical to prevent gaming of the system to undermine the economic tie between the originator and the issued ABS, according to the administration.

Under the proposals, federal banking agencies will be given the authority to specify the permissible forms of required risk retention (for example, first loss position or pro rata vertical slice) and the minimum duration of the required risk retention. The agencies will also have authority to provide exceptions or adjustments to these requirements as needed, as well as to apply the requirements to securitisation sponsors rather than loan originators in order to achieve the appropriate alignment of incentives.

The ASF says that while it supports policy initiatives to align economic incentives among securitisation market participants and to achieve greater risk transparency, it believes that mandated retention of risk by asset originators and securitisation sponsors may not be the most effective way to achieve this goal.

"To the extent risk retention is required, we believe provisions must be designed carefully to avoid undue restrictions on the ability to fund consumer and business lending via securitisation, which could impair broader economic recovery. Risk retention is also an area where EU policymakers are focused; given the global nature of capital flows, achieving international consistency on this topic is critically important," Miller explains.

The plan also envisages facilitating investor and credit rating agency (CRA) access to the information necessary to assess the credit quality of the assets underlying a securitisation transaction at inception and over its life, as well as the information necessary to assess the credit, market, liquidity and other risks of ABS. In particular, the issuers of ABS should be required to disclose loan-level data.

They will also be required to disclose the nature and extent of broker, originator and sponsor compensation and risk retention for each securitisation. In addition, the SEC and the Financial Industry Regulatory Authority (FINRA) are being urged to expand the Trade Reporting and Compliance Engine (TRACE) to include ABS.

With respect to CRAs, the SEC is expected to continue its efforts to strengthen regulation of the sector, including measures to promote robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise strengthen the integrity of the ratings process (see also separate News story).

Culhane anticipates that the market's revival will partially be driven by the new regulations, but mainly by investors coming back into the sector and taking a bottom-up approach in terms of pricing risk. He reports that the past few months have seen a greater willingness among industry participants to acknowledge their problems, with some now actively trading out of the positions they don't like.

He concludes: "Investors, in particular Middle Eastern accounts, are now at the stage where they're contemplating re-entering the market. But their appetite for risk is extremely limited - they'll consider only the most conservative deal with the cleanest collateral. Under this scenario, originators will likely seek investor feedback about a proposed issuance in terms of the capital structure, LTV, margin characteristics and their comfort with the proposed subordination."

CS

Indices

Hedge fund index stays positive

Both gross and net monthly returns for April 2009 in the Palomar Structured Credit Hedge Fund (SC HF) Index have again been positive - posting the highest ever month on month increase seen in the Index. However, participating funds in the Index fell to an all time low of 14, from a high of 40 seen in July 2007.

The latest figures for the index were published this week and show a gross return of 2.73% and a net return of 2.34% for the month of April. Nevertheless, the gross and net indices still show negative, albeit improved, annualised returns since outset of -8.37% and -10.22%. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. It currently tracks 15 funds and represents over US$7.5bn of assets under management.

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

The Palomar SC HF Index is calculated by the Centre of Alternative Investments of the Zurich University of Applied Sciences and run by Palomar Capital Advisors. It is published exclusively by Structured Credit Investor.

Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

Operations

Securitisation produced 'significant economic benefits'

The American Securitization Forum (ASF) has released the results of a study assessing the long term impact of securitisation, with a focus on the RMBS market. The study analysed the impact of securitisation on the cost and availability of credit, as well as how securitisation affects market liquidity and the distribution of risk.

Based on an extensive review of loan-level and other data over the period 1990 through 2006, the study found that securitisation has produced significant economic benefits. These include:

• Lowered cost of consumer credit, reducing yield spreads across a range of products including certain types of mortgages, credit card receivables and automobile loans.
• Increases in the secondary market purchases and securitisation of mortgage loans have positive and significant impacts on the amount of mortgage credit available per capita, including among traditionally underserved populations. Conversely, the study found that declines in secondary market purchase and securitisation activities negatively impact the amount of available mortgage credit to consumers.
• A reduction in securitisation activity has a negative impact on all types of lending activity, including but not limited to residential mortgages.
• The study predicts that bank lending activity is likely to be significantly and negatively impacted if securitisation remains at its current, depressed level.
• Delinquency rates for securitised subprime mortgage loans are not statistically different from delinquency rates for all subprime loans, even in recent years, and the credit performance of securitised and non-securitised jumbo and alternative-A mortgage loans are similar over the past decade.

"This study demonstrates that securitisation has historically produced broadly desirable and beneficial outcomes: cheaper and more plentiful credit for consumers and businesses; an efficient source of liquidity and financing for issuers; highly customised and diverse investment opportunities for investors," says George Miller, ASF executive director. "At the same time, there can be no doubt that some uses of securitisation have produced marginal or negative outcomes, by funding unaffordable or unsuitable lending products, or by concentrating rather than dispersing risk."

"These outcomes are not linked to securitisation per se, but how this technology is used by market participants to fund, transfer and assume various risks associated with securitisation activities," he adds.

In a companion document released simultaneously with the completed study, the ASF notes several important perspectives that should be considered in any critical examination of the role, impact and benefits of securitisation. These include:

• Research results indicating that securitisation can be beneficial, or that securitisation has been beneficial in the past, does not necessarily mean that securitisation is inherently or always beneficial. Recent experience demonstrates that securitisation is not inherently 'good' or 'bad'. As with other financial technologies, the final judgment depends upon the application and results of securitisation in specific settings.
• Securitisation can be used in ways that reduce and distribute risk, or that increase and concentrate risk. In its basic form, funding assets via securitisation is a zero-sum game that redistributes a finite amount of risk. The amount of risk inherent in a securitisation is equal to the risk embedded in the securitised assets themselves, and the act of securitisation neither increases nor decreases the aggregate amount of that risk. However, related and ancillary practices and strategies employed in some securitisation transactions by some market participants can amplify and concentrate those risks.
• While securitisation has sometimes been criticised as 'marginal' or 'esoteric', it is in fact a central and mainstream financing technique. Over the past 40 years, securitisation has grown in the US to fund approximately one-half of all extensions of consumer credit, with a higher share in some products such as residential mortgage loans.
• Securitisation is necessary. While there are valid criticisms of imprudent uses of securitisation, as numerous policymaking bodies have recognised, it nevertheless represents an essential tool for delivering affordable credit to consumers and businesses, and is a necessary ingredient in the path to global economic recovery and growth. This is especially true in light of current capital and liquidity constraints confronting financial institutions and markets.

The study explores the impact of securitisation on four areas: the cost of credit, the availability of credit, the dispersion of risk and liquidity. It was conducted by National Economic Research Associates (NERA) and was commissioned by the ASF in the fall of 2007 to evaluate the impact of securitisation to consumers, investors and the broader financial markets. A primary motivation for commissioning this study was ASF's assessment that, notwithstanding the size, scope and significance of securitisation market activities as of the mid-2000s, there was surprisingly little academic or other research that attempted to evaluate and quantify the broader economic impact of securitisation in an analytically rigorous way.

CS

Ratings

Ratings proposals under fire

The Obama administration's plan for financial regulatory reform (see also separate News Analysis story) engendered two separate responses about credit ratings. One addressed the potential for 'ratings shopping', while the other concerned using rating differentiators for structured finance product.

Realpoint called for the reform to specifically address the problems that led to the lack of independence by the major credit rating agencies, which "have shown they are more concerned about market share than accurate and timely risk analysis".

Robert Dobilas, the agency's president and ceo, explains: "In the current ratings model, compensation and attention is focused almost exclusively on presale ratings." He says the integrity of the new-issue ratings process is undermined by the pervasive practice of 'shopping' for preliminary ratings.

"The solution," adds Dobilas, "only takes one step; namely, requiring all the Nationally Recognized Statistical Rating Organizations to receive the same information, at the same time, so they can prepare their own ratings regardless of whether they are ultimately hired by the issuer of the securities."

Realpoint notes that the administration has an excellent opportunity to make a simple change that it believes will have an immediate and dramatic impact, and ultimately help to restore investor confidence in the credit rating process.

Meanwhile, in a letter to its members, CMSA president Patrick Sargent has strongly re-stated the association's long-standing opposition to any plan that includes credit rating differentiation for structured products. "The association always has advocated some checks-and-balances for rating agencies to avoid conflicts of interest, and has strongly supported the need for additional transparency in ratings and the methodologies used by the rating agencies, but we strongly oppose differentiation of ratings described in the White House provisions which, we feel, causes both confusion and implementation issues," he writes in the letter.

The letter continues: "Indeed, the issue of ratings differentiation reopens a previously settled debate; a debate that will greatly delay and exacerbate market recovery. Investors have been very clear that imposing differentiation across structured finance does not enhance the understanding of certain ratings - it only creates more confusion and more uncertainty."

AC & CS

Structuring/Primary market

Structural concerns linger for Tesco CMBS

Tesco Property Finance 1, a UK CMBS that was publicly marketed to investors via Goldman Sachs last week (see last week's issue), priced at 340bp over mid-swaps - the lower end of the guidance range. The transaction was upsized from £415m to £430m and was three times oversubscribed, with paper placed across approximately 60 accounts. Buy-and-hold investors dominated, as pension funds and asset managers took 85% of the issue.

Yet despite the deal's success, there remain some doubts over the stability of its rating, as well as the strength of the underlying portfolio. Furthermore, in spite of the 'simplicity' of the single-tranche structure, the deal is not as straightforward as it may first appear.

Jean-David Cirotteau, ABS analyst at Société Générale, points out that Tesco used three existing vehicles in the deal (two borrowers and one issuer). "While this is similar to some two-step securitisations seen in the past, it also creates some uncertainty due to potential pre-existing debt within these entities," he says.

He adds that there is also complexity around the cashflows in the structure: there are specific swaps between each borrower and the issuer, with back-to-back swaps between the issuer and Tesco Plc, which itself acts as issuer swap provider. "At borrower/issuer level, the swaps comprise an index-linked payment based on the tenant leases paid by each borrower, while the issuer pays the fixed interest and principal payments equivalent to the loan installments agreed with the corresponding borrower," he explains.

Cirotteau is also concerned about the credit quality of Tesco Plc, pointing out that SG's consumer sector analysts are negative on the name and recommend buying protection on its CDS. He has some doubts about the strength of the underlying securities, as well. The underlying assets are generally located in weaker economic regions and one of the properties is still being constructed.

"The difference between the market value (MV) of properties and their vacancy possession value (VPV) is one explanation for this uncertainty (MV LTV 91.6% according to S&P; Moody's VPV LTV is 136%)," Cirotteau continues. "It is therefore important to consider to what extent this investment is really secured by the properties."

Cirotteau explains that the deal is very tax-oriented and enables Tesco to restructure its debt. However, he adds that there is no deleveraging of Tesco itself, as the properties are not sold in the market.

"There is definitely no real estate market to buy such investments at the moment. We think Tesco has managed to lift more debt than the embedded property value of the securitised pool," he concludes. "We expect the bond's rating to be as volatile as those of Tesco itself in the coming months."

AC

Secondary markets

The new norm

Nicholas Stewart, head of structured credit products at Prime Source, answers SCI's questions

Nick Stewart

Q: How and when did Prime Source become involved in the structured credit/ABS market?
A: Prime Source (NYSE Euronext) Limited was launched in early 2008 by NYSE Euronext group as part of its drive to provide more transparent and reliable independent asset pricing to the market. The Prime Source service has been built by merging an existing business on structured credit and a new platform for the valuation of other asset classes and by signing strategic partnerships with renowned specialised firms.

The business had initially become involved in complex structured credit valuations in 2006, leveraging off a strategic partnership with analytics software provider, CDO2 Solutions, and leveraging off the business's existing well-regarded capabilities for valuing more vanilla credit derivatives such as CDS.

Q: How has your service/offering developed since then?
A: Over the last two years, the key areas of development in structured credit have been in building a systems infrastructure that allows for a high degree of transparency and automation across multiple position valuations. Of particular focus more recently for the valuations of synthetic structures has been the issue of calibration in a volatile and relatively illiquid credit correlation market and Prime Source has worked closely with CDO2 Solutions in implementing a variety of alternative market-standard approaches to deal with this.

We have recently extended our capabilities to cover the valuations of complex structured credit securities with cash collateral underlyings, such as CLOs, ABS, CMBS, RMBS, trust preferred structures and ABS CDOs etc. The valuations are based on detailed assessment and modelling of the underlying collateral, as well as the features of each structure. This is being handled in partnership with a team of very experienced practitioners and advisers in these markets.

Q: Which market constituent is your main client base?
A: Historically our client base has consisted of principally buy-side participants such as hedge funds, mutual funds and asset managers, including their custodians and administrators. After the recent market turmoil, we are seeing growing demand for independent valuations and verifications from sell-side institutions that need to demonstrate more effectively to investors and regulators, as well as for their own compliance purposes, that their pricing is fair and transparent. We have seen quite a significant growth in demand for our services from structuring desks and product controllers at sell-side firms.

Q: Do you focus on a broad range of asset classes or only one?
A: Across the business as a whole we provide modelled values, as well as contributed and evaluated prices, on a wide range of products and asset classes. There is very strong client interest in our ability to value, with complete independence and full transparency, a wide range of assets and structures - from fairly vanilla derivatives, such as for example CDS or equity variance swaps or interest rate swaptions handled through highly efficient and fast processes, through to the breadth of bespoke structured products and complex securities. This breadth makes Prime Source a very compelling and comprehensive valuation service provider.

Q: How do you differentiate yourself from your competitors?
A: Aside from the breadth of our coverage, one of the key differentiators for us is the extent of our interaction with clients, particularly on the hard-to-value structured products. The NYSE Euronext group has a very strong culture of client relationship and support. We maintain an informed dialogue with clients, enabling us to keep in touch with latest market developments and allowing us to refine our levels of scrutiny when it comes to generating accurate and reliable valuations, including for hard-to-value structures.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
A: The current environment has seen radical changes in the financial markets, particularly in structured products. After the collapse in confidence of the ratings industry and regulators alike, we are receiving more valuation requests for bespoke structures and complex securities such as ABS CDOs, particularly in cases where the originating institution is no longer making a market in the products and investors have few alternatives available for fair and accurate pricing. Being able to respond quickly and reliably to such requests has necessitated increased flexibility in terms of our processes and our modelling and data resources.

Q: What major developments do you need/expect from the market in the future?
A: The ongoing debate about reorganising the OTC derivatives market along the lines of the exchanges is likely to produce a sea-change not only in the way that business is transacted, most obviously mitigating counterparty risk, but also in the way in which models and model risk becomes far less opaque. Until this happens and the inherent risks are better understood by all concerned, product innovation cannot return any time soon. In the short to medium term, we expect to see new structured credit products or variants of existing ones, where structural simplicity and widely available information on the performance of the underlying collateral become the norms.

www.nyxprimesource.com

Advisory

Structured credit head joins advisory

Zucker & Co investment advisors have announced that Rick Weinstein joined the newly established firm at the beginning of June this year. Set up in March by Olivier Zucker, the financial services firm is based in London but also advises clients in Switzerland, wider Europe and the Middle East.

Weinstein joins the firm with over 20 years of capital markets experience in a variety of roles from interest rate, equity and credit derivatives to structured finance and illiquid debt markets. Most recently, he has advised a Russian bank on its capital markets strategy and was a partner in the start-up finance boutique Richmond Park.

Prior to this, Weinstein was an md at Dresdner Kleinwort, where he led the global structured credit business. He has also worked at Indosuez, JPMorgan, Drexel and Chase, where he built and led businesses in a number of jurisdictions, including London, Tokyo, Zurich and New York.

Zucker & Co aims to offer independent investment advisory and consultancy services to private clients, trustees and financial intermediaries.

CDO

Court of Appeal affirms HSH Nordbank/UBS ruling

A UK Court of Appeal judgment has affirmed a lower court ruling dismissing a claim brought in London by UBS against HSH Nordbank. In UBS AG & another v. HSH Nordbank AG, the Court of Appeal upheld the decision of Justice Walker who, in an earlier decision in favour of HSH Nordbank, held that the English courts had no jurisdiction to hear the matter.

Partners at law firm Quinn Emanuel note that the decision establishes an important precedent for jurisdictional disputes in complex financial transactions, which involve a number of separate agreements, often between several parties. "It is already apparent that the judgment will have much wider implications, as the Court of Appeal's approach set out in the decision can be applied to all complex commercial deals which comprise several contracts with competing jurisdiction clauses."

The case is in connection with the North Street Referenced Linked Notes 02-4 transaction, a synthetic CDO sold to HSH Nordbank by UBS (see also SCI issue 96).

CDPCs

Senior advisor joins CDPC asset management unit

Primus Asset Management has appointed Bryan Dunn as new senior advisor to the company. Dunn, who will report to Primus Guaranty's ceo Thomas Jasper, will focus on the strategic development of PAM's credit asset management business (SCI passim).

Throughout his career, Dunn has established a number of credit-related businesses. Most recently, as group head of the credit portfolio management division at Bank of Tokyo-Mitsubishi, he formulated the bank's secondary credit market business strategies and oversaw the development of its credit portfolio management and proprietary credit investing efforts. Prior to that, he established credit businesses at both Dresdner Kleinwort and CIBC.

Jasper says: "In the current market environment, there continues to be interesting opportunities to develop credit investment products and offerings that meet the needs of market participants. Bryan's credit market knowledge and experience will bring important benefits to Primus as we work to leverage our expertise and operating platform to capture these opportunities and grow our asset management business."

Primus Asset Management currently has over US$23bn in assets under management in structured credit vehicles. This includes the US$21bnnotional credit default swaps portfolio of Primus Financial Products, as well as two CLOs and three CSOs. PAM recently signed a definitive agreement to acquire CypressTree Investment Management, which manages leveraged loans and high yield bond portfolios totalling approximately US$2.4bn in a variety of investment products.

Distressed assets

Firms join forces to service distressed assets

LaCrosse Global Fund Services and Ocwen Financial Corporation have introduced a suite of services available to investment funds investing in US-based loans, mortgages and distressed assets. Ocwen will provide seamless integration of its mortgage servicing and valuation offerings to customers of LaCrosseMortgage+, a fund administration and middle-office support package for investment funds that trade in whole loans.

Rapid growth in fund structures aimed at investments in commercial mortgages, residential mortgages, MBS and related derivatives requires increasingly high levels of service requirements in the real estate arena, the two firms note. To meet this need, their partnership offers a complete back office solution that includes fund administration services and progressive real estate expertise in loan servicing and valuation. LaCrosse and Ocwen will work together to develop solutions to meet clients' specific needs in these areas.

"Our goal is to take advantage of the recent burgeoning in investment vehicles for purchasing both performing and non-performing mortgage loans. These vehicles have administrative and operational requirements that are often different from typical hedge funds and private equity funds, and LaCrosse has developed unique expertise in servicing this type of investment. Our partnership with Ocwen complements the current operational and administrative support platform that LaCrosse offers to its clients in support of operational best practices," says Stuart Feffer, co-ceo of LaCrosse.

Listed products

Permacap's performance on the up

Carador has reported that, as at the close of business on 31 May 2009, its unaudited net asset values per share were €0.4264 and US$0.550. Monthly performance was 1.62% and 2.35% respectively.

This month's calculations include an estimated €1,260,826.68 of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0092 or US$0.0130 per share.

Monolines

Renfield-Miller resigns as Everspan launch fails

Ambac evp Douglas Renfield-Miller has announced his resignation from the company, effective as of 1 January 2010. This decision comes in light of the failed launch and postponement of Ambac's Everspan Financial Guarantee Corporation, of which Renfield-Miller was ceo.

Ambac had been seeking to launch Everspan in order to write financial guarantee insurance in the public finance market as a separate, stand-alone legal entity. However, the monoline has so far been unable to secure the third-party capital necessary to receive sufficient financial strength ratings to compete in the targeted market. Although Ambac engaged in discussions with third parties to raise capital for Everspan, none of the discussions resulted in a satisfactory outcome.

David Wallis, Ambac's president and ceo, comments: "Postponing this strategic initiative was a difficult decision. We will closely monitor the capital markets and will revisit this opportunity when the economic environment has stabilised."

As a result, Renfield-Miller has announced his retirement from both Ambac and Everspan, but will provide support and consultation to Ambac until 31 December 2009.

Ratings

DSCM mandates confirmed

S&P has issued a final rating confirmation with respect to Dock Street Capital Management (DSCM) as the replacement collateral manager for Robeco High Grade CDO 1. The transaction was previously managed by KBC Structured Investment Management. The other outstanding S&P publicly-rated CDOs that DSCM currently manages are Jupiter High-Grade CDO V and Wadsworth CDO.

Ratings

Mortgage servicer rating withdrawn

Fitch has withdrawn M&T Bank's US residential mortgage servicer rating of RPS2. The withdrawal is based on the fact that there is insufficient information to maintain the rating.

Technology

Desktop application to focus on US RMBS

Fitch Solutions and Portsmouth Financial Systems have partnered to launch Deal View, a desktop application that offers loan-level analytics for the US structured finance market. The inaugural edition of Deal View will focus on the US RMBS sector.

Deal View provides users with historical and current collateral data, prepayment and default modelling capabilities, loan-level analytics and scenario analysis for all major segments of the US RMBS market, including subprime, Alt-A and prime. Additional asset classes will be forthcoming, the two firms note.

 Portsmouth Financial Systems ceo Michael Megliola says: "Deal View provides the market with more granular structured finance analytics at the loan, bond and deal level."

 Analytics are user-defined, allowing unique insight into the asset quality of loans underlying US RMBS. A user can, for example, compare prepayment and default rates for arbitrary loan pools, or run interactive yield tables on any collection of loans.

Fitch Solutions group md Gloria Aviotti adds: "The flexibility and speed with which a user can evaluate collateral level performance trends using Deal View provides for a more accurate assessment of the future risks within a bond and brings a new level of transparency to the structured finance market."

Trading

Structured sales and trading operation launched

Aladdin Capital has launched a sales and trading operation in London, as part of the firm's ongoing transformation from asset manager to boutique investment bank. Headed up by Michael Gibbons, former head of distressed debt and special situations at BNP Paribas in London, the sales and trading team will comprise 15 members. Ten of these have already been hired, with an additional five expected to be hired later this summer.

The sales and trading operation will primarily focus on structure-intensive credit assets as well as distressed debt, and will cover the full spectrum of structured finance securities, including ABS, RMBS, CMBS, CDOs, CLOs, and structured solutions.

The ten new hires - to be announced later this week - have approximately 150 years of experience in the markets between them.

Trading

Trading platform set to expand

Beacon Capital Markets plans to expand its trade discovery platform to include non-agency MBS, ABS and CMBS beginning on 10 July 2009. Market participants will be able to trade the full range of private label or non-agency MBS, including RMBS and CMBS. In addition, the full array of ABS will be accessible, including auto loans, credit card and home equity ABS.

Beacon Capital Markets co-founder and coo Rob Barsky says: "The addition of non-agency MBS, ABS and CMBS trading is a natural step in the growth and development of our platform. Market participants have urged us to add these less liquid securities to the platform and, given the challenges in the current market, we believe the timing is right to offer this expanded line up."

Market participants can locate and trade non-agency MBS and ABS using search methods specifically fine-tuned for these securities. Trades are negotiated anonymously and automatically captured, creating an electronic audit trail.

Barsky continues: "Our platform is focused on providing price discovery and efficient executions. Particularly at a time when market participants face challenges trading in these markets, our platform represents a tool providing more efficient access to pools of liquidity.

ABS

Portfolio uncertainty for Pillar ABS notes

Moody's has placed all notes of Pillar Funding Series 2005-1 issued out of the Arch Funding Receivables credit card master trust on review for possible downgrade. The assets backing the notes in the master trust are receivables arising under designated revolving credit card accounts originated by Egg Banking, a wholly owned subsidiary of Citigroup.

The review has been prompted by Moody's concerns surrounding the ability of Egg to maintain a non-declining receivable pool balance in a stressed scenario. The assumption on whether a pool balance is declining in a stressed scenario is a key consideration for the 'purchase rate' assumption for the trust and takes into account the willingness and ability (as implied by the senior unsecured rating) of the parent of the originator to generate new receivables on an ongoing basis in such a scenario.

While Moody's notes that Citigroup has displayed commitment to Egg's card business in the past, the agency is less able to assess with certainty the likelihood of future support from Citigroup to Egg due to the lack of clarity as to whether certain reported performance metrics correctly reflect the true performance of the portfolio.

This situation has arisen as a result of Egg exercising its option on several occasions to repurchase delinquent accounts from the receivables trust at par, resulting in an understatement of what Moody's believes is the true level of charge-offs of the portfolio. Given this uncertainty as to the real performance of the portfolio and the relatively small size of Egg's card business in comparison to the overall asset portfolio of Citigroup, Moody's now considers that there is an increased likelihood that a stressed scenario where the pool balance of the trust may decline would be observed in relation to the Arch Funding Receivables trust.

CDS

Auction results in, more expected

Credit event auctions for JSC Alliance Bank (CDS trades settled at 16.75, with 12 dealers participating) and Visteon (CDS settled at 3, with 12 dealers participating; LCDS settled at 39, with 10 dealers participating) were undertaken this week. Auctions for R.H. Donnelley, Dex Media East and Dex Media West are due to be settled today, 24 June.

Meanwhile, Legal & General Investment Management has asked the ISDA Determinations Committee to determine whether a bankruptcy credit event has occurred on Bradford & Bingley (SCI passim), the decision about which has been deferred until July.

CLOs

Synthetic CLO bought back

Rabobank's tender offer for its synthetic balance sheet CLO Sundial 2004-1 saw €199m of notes being bought back from the Class A, B, C and D tranches at prices ranging between 92% and 55%.

CLOs

Moody's launches CLO newsletter, reviews EODs

To help market participants stay current on its ongoing views of credit issues involving CLOs, Moody's has launched a new monthly newsletter entitled 'CLO Interest'.

"Our goal is to publish timely topical articles and news stories of key interest to global market participants," says Moody's group md Yvonne Fu. "The newsletter is part of Moody's ongoing effort to make it easier for investors to stay abreast of our thinking on breaking credit issues."

Articles in the first issue explore changes to Moody's CLO rating models, issues surrounding deeply discounted securities and CLO events of default (EODs), as well as the agency's recent CLO rating sweep. Discussing the exposures of US CLOs to the troubled US auto-makers, for example, the agency says most transactions do have some exposures, but these are typically limited and spread across several names.

The newsletter also states that CLOs that have recently experienced EODs may be "the exceptions rather than the norm", in a preview of an upcoming Moody's study. "Our preliminary finding is that EODs are indeed a concern for some CLOs, but they may not be as widespread as some market participants are suggesting," the agency notes.

Nonetheless, the study - which reviewed 100 CLOs - provides some interesting conclusions. On the positive side, 29 of the transactions either do not incorporate deep discount or excess Caa par haircuts in their EOD OC or simply have no OC-based EODs. Senior OC levels (an average of 123% at the end of May) are shown to generally remain healthy, making the risk of hitting triggers still somewhat remote. Additionally, EODs do not automatically result in liquidation as most deals require a super-majority vote of all debt classes and can result in an acceleration that is favourable to senior classes.

More concerning, however, is that the study shows growth in Caa-rated loans is threatening to accelerate OC declines in some deals, as Caa bucket limits are exceeded and loan prices average well below par. One of the 100 deals reviewed uses a market value-based OC test of the sort that recently caused EODs, while another nine are probably at high risk due to deteriorated OC levels or other factors.

"There are some wildcards in trying to predict EOD occurrences. As credit markets continue to deteriorate, so will OC levels, increasing the risk of an EOD," Moody's says. Compliance risk and operational errors further increase this risk.

CMBS

Euro CMBS deals under water

A number of European CMBS have recently breached, or are close to breaching their financial covenants (see also separate News Analysis).

The latest servicer report for SG's UK CMBS White Tower 2006-3 indicates that the value of the underlying properties has fallen to £929m - down 49.3% from £1.832bn when the deal was issued in November 2006. "Given the £1.15bn in outstanding bonds, the LTV is 124% and in clear breach of the LTV covenant," CMBS analysts at Barclays Capital note. "Based on the limited cure period of 10 days, we expect that there will be a loan event of default shortly."

Net rents stand at £88.8m, which implies a 9.6% initial yield. "A forced sale of the nine assets will be partially hampered by the lack of debt financing in the current market," the analysts add. "But, in our view, the 9.6% initial yield already assumes a significant forced sale discount. If we were to apply a 20% forced sale discount and 7% costs - similar to our severe stress assumptions in other deals - this would trigger a marginal £0.3m or 0.04% loss to the Class A notes."

However, BarCap believes that a 10% forced sale discount is more appropriate on top of the current (distressed) value. This would result in no loss to the Class As and a £88m (or 51%) loss to the Class Bs - double the worst-case loss estimated in the analysts' original worst-case stress for the deal from November 2008.

Meanwhile, the borrower on the Eclipse 2006-4 (Hercules) transaction, who is now in breach of the cure period, has reported that it was doing its best to replace vacancies by 30 June. The servicer is said to have decided not to receive supplementary fees due under the documentation.

Finally, the new valuation of the three properties (unanchored retail) under the Shrewsbury mortgage loan in the Windermere XI deal was £46.5m as of May 2009, compared to the offering circular valuation of £118m in March 2006. The securitised loan is the A piece of an A/B structure loan. The ICR has been in breach since Q408, as repayments were impaired by the insolvency of Woolworths.

CMBS

Freddie multifamily CMBS oversubscribed

Freddie Mac has completed its Series K-003 Structured Pass-Through Certificates, a multifamily CMBS. All classes of notes were between 1.1x and 6.1x oversubscribed.

K Certificates are backed by multifamily mortgages originated through the Freddie Mac Capital Markets Execution (CME) platform. "CME offers our customers a more standardised multifamily mortgage product with better pricing," comments David Brickman, vp of multifamily and CMBS capital markets for Freddie Mac. "We expect to expand our securities activities and see a growing volume of multifamily loans coming through our CME pipeline."

The K Certificates were offered to the market by a network of dealers led by Deutsche Bank Securities. Investors were large money managers, life insurance companies and pension funds.

CMBS

EMEA CMBS deterioration accelerates

The performance deterioration of CMBS and multi-family transactions in EMEA accelerated in Q109, according to Moody's.

"As anticipated, there was an increase in number of loans facing adverse issues and the number of loans subject to an event of default increased over the past quarter," says Lifang Chen, a Moody's senior associate. Compared to previous quarters, the performance deterioration accelerated, with the number of loans subject to an event of default nearly doubling and arrears levels increasing significantly over the past quarter.

Continuing the trend from the past few quarters, the number of loans subject to LTV covenant breaches increased in Q109 as more revaluations were carried out. Moody's has also observed an increasing number of loans breaching their debt service coverage covenants due to decreasing property cashflows.

"Going forward, the most concerning performance factor in EMEA CMBS is refinancing risk. While the refinancing exposure of EMEA CMBS in 2009 and 2010 is still remote, one has to look further ahead. Given the most recent commercial property market performance and the anticipation of further property value declines, also loans that mature after 2010 will be highly levered on their refinancing date and will most likely experience difficulties to repay," notes Deniz Yegenaga, a Moody's associate analyst.

He continues: "In addition, the significantly declining property values increase the loss upon default of commercial real estate loans."

CMBS

CMBS loans of concern expected to increase

Fitch has reported in the latest US CMBS VintageView results that despite recent growth in reported net operating income (NOI), its loans of concern are expected to continue their climb. With nearly half of the loans in the Fitch-rated universe reporting year-end 2008 operating performance, NOI is reported to have increased by an average of 4% year over year.

Fitch md, Mary MacNeill, says: "As additional loans report year-end financials, Fitch expects NOI growth to slow as better performing loans generally report performance earlier than poorer performing loans, leading to the current year-on-year NOI increase. Fitch loans of concern are expected to rise, especially in earlier vintages, with adverse selection and later vintages with aggressive underwriting."
Fitch loans of concern are up 53bp in fixed-rate multiborrower transactions due to deteriorating performance. Transactions that were originated in 1999 and prior, as well as in 2007 and 2008, contain above the average of 14.17% loans of concern. Transactions from 1999 and prior vintages exhibit adverse selection. Loans in 2007 and 2008 transactions were originated at peak market conditions and have shown signs of weakening performance.

Loans of concern in floating-rate transactions are down 12bp from the prior month, but remain high at 25.01%. This is due to the non-stabilised nature of the loans. Also, there is near-term refinance risk due to the shorter loan terms and the lack of liquidity in the current market.

Indices

Volatility at last for MCDX?

The Markit MCDX index spiked at 200bp on 18 June, with five-year California exposure heard to be offered at 330bp. Market rumour indicates that a credit event on California bonds could be in line to trigger CDS, bringing some much-needed volatility to the index (see SCI issue 131).

There appears to be some uncertainty about how a California credit event would play out, with some brokers and end-users expressing concerns over the auction settlement process and lack of ability to accelerate obligations in muni-land, according to analysts at Credit Derivatives Research.

"We think, given the < six-month horizon on this event risk, that a short CALI, long muni index (buy CALI protection, sell MCDX protection) may be the cheapest way to play for a credit event and, given where non-BABS are trading, we might see 60%-70% recoveries," they comment.

Indices

Sharp improvement in home prices

The latest LoanPerformance home price index data indicates a sharp improvement. Figures for April fell by -9.53% one-month annualised, while for March the figure was -11.43% and for February -19.44%.

"Historically, April has been the second strongest month for home prices, after May, partially explaining the recent positive trend," ABS analysts at JPMorgan note. "At -15.63% year-over-year price declines, we are still far away from the flat territory, but this is a major improvement from the -18% to -19% area during the second half of last year. The other main home price indices, FHFA and Case-Shiller, have also started to experience improvement."

The JPMorgan HPI model suggests that there is a V-shaped recovery ahead in home price appreciation. The model projects that year-over-year HPA has already bottomed, and the price declines will turn and move slowly to flat and positive territory over about two years.

Currently, the drop from peak is at -32.18% for Case-Shiller national and -11.15% for the FHFA purchase only, while the JPMorgan model is projecting another -13% and -11% decline respectively. The projected peak-to-trough declines are -41%, -21% and -45% for Case-Shiller, FHFA and LoanPerformance respectively.

Indices

CMBX 1 projected losses increase by nearly 36%

As of the May 2009 remittance reports, CMBX 1 fundamentals have started to show new signs of stress, according to Realpoint. The rating agency notes that this may be the beginning of significant deterioration in the index, similar to the trends witnessed across the later indices.

"The CMBX 1 index was previously performing significantly better than its later vintage cohorts, as it wasn't subject to the looser underwriting standards and other overzealous activities the later indices were," says Realpoint. "Based on the new data it appears the pressure on commercial real estate fundamentals may be spreading from these 'aggressively underwritten' loans to more conservative performing loans."

This deterioration can be seen in the growth of Realpoint projected losses, which were driven by the increase of specially-serviced and delinquent loans from the April 2009 remittance to the May 2009 remittance. Projected losses rose by nearly 36% to more than US$500bn, with the vast majority of this coming from increased losses on specially-serviced loans.

Exposure to specially-serviced loans in CMBX 1 grew to 5% of the index, up from 2.2% the prior month. This is an increase of 130% month over month.

Realpoint says the specially-serviced growth may continue to climb over the next month as delinquencies in the 30-day category grew 40% for the same period and may be moved into the 60-day bucket next month. This increase in 30-day delinquent loans has helped to push the delinquency rate up to 1.65% for the May remittance from 1.19% for April.

"While the CMBX 1 index has just begun to show additional signs of stress, the later indices are still significantly underperforming it," comments Realpoint. "All other indices have a delinquency rate of at least 2.5%, and appear to be poised to continue their upward trend. We do note that delinquencies for the CMBX 3 and 4 indices were down slightly for the May remittance; however, this is due to several large Bethany loans being brought current, which helped to lower the overall dollar amount of delinquent loans, but the total number of loans that are delinquent rose."

Indices

Playing the normalisation trend

With the market appearing to be in a 'recovery mood', but at risk of a short-term correction as suggested by mixed normalisation indicators, credit strategists at BNP Paribas suggest that decompression/stabilisation trades are appropriate at present.

"We believe that the recent rally has led to excessive outperformance in higher-beta sectors. In this context, a decompression trade between high beta and low beta should perform well under a possible 'correction' scenario, and have limited downside under a 'continued tightening' one," they explain.

The trade can be implemented in the CDS space by going long iTraxx Main versus short HiVol, particularly in Series 10, which comprises several auto names.

Operations

July TALF operation announced

The New York Fed has announced the 7 July operation for non mortgage-backed ABS. The subscription date will run from 7 July to 14 July. Loan terms of three and five years will be offered, with an administrative fee of 5bp. Rates will be set at 12pm EST on 7 July.

Ratings

Prime jumbo RMBS hit

S&P has lowered its ratings on a number of US prime jumbo RMBS transactions. Ratings have been lowered on 102 classes from 33 deals issued from 1998 to 2004, and on 956 classes from 93 RMBS transactions issued in 2005, 2006 and 2007. 664 of the lowered ratings were removed from credit watch with negative implications.

In addition, ratings on 246 classes from 32 of the downgraded transactions and eight additional transactions were affirmed and 98 of the affirmed ratings were removed from watch negative.

S&P has stated that the ratings downgrades are due to the insufficient projected credit support to maintain the previous ratings of the affected classes, given the current projected losses. To assess the creditworthiness of each class, the agency reviewed the individual delinquency and loss trends of each transaction and changes in risk characteristics, servicing and the ability to withstand additional credit deterioration.

For mortgage pools that are continuing to experience increasing delinquencies, stresses were increased to account for potential increases in monthly losses. In order to maintain a rating higher than single-B, it was assessed whether a class could absorb losses in excess of the base-case loss assumptions the agency assumed in its analysis. For example, whether one class could withstand approximately 130% of base-case loss assumptions in order to maintain a double-B rating, and whether a different class could withstand 155% of the base-case loss assumption to maintain a triple-B rating.

S&P has reserved a triple-A rating for deals that can withstand approximately 235% base-case loss assumptions. Subordination provides credit support for the affected transactions. The underlying pool of loans backing these transactions consists of fixed- and adjustable-rate, first-lien prime jumbo mortgage loans.

Ratings

FAS 166 and 167 unlikely to impact credit ratings

Fitch says it does not expect FAS 166 and FAS 167, relating to the reconsolidation of off-balance sheet securitisations, to result in negative rating actions as the economics of the off-balance sheet transactions will remain the same. The agency does, however, believe there will be challenges for issuers and analysts in transitioning to a new set of accounting standards.

"For issuers, the structuring of financial products could change, as the qualified special purpose entity ceases to exist and the test for consolidation of variable interest entities switches to a qualitative focus from a quantitative one," says Fitch senior director Meghan Crowe. "Furthermore, eliminating the regulatory capital arbitrage associated with off-balance sheet accounting could yield lower ABS volumes, although Fitch believes this market will remain a necessary component of many issuer funding profiles."

The agency notes that analysts will need to deal with changes in financial statement content, which could hamper the evaluation of credit on a historical and relative basis and it could become more difficult to identify unencumbered assets with more secured financing added to the balance sheet. Additionally, the four measurement methods for re-consolidation, permitted by FASB, could make peer comparisons more difficult going forward, it says.

Ratings

Loan recoveries shift dramatically lower

Based on data obtained from its shadow rating process for CLOs and other structured vehicles, Fitch notes that the loan recovery ratings (RRs) it assigned to leveraged loans experienced a pronounced shift to lower RR categories during the first quarter of 2009. Recovery ratings in the RR1 (90%−100% recovery) category declined noticeably, while those in the lower RR categories increased (with the exception of the RR5 category).

Fitch believes the shift to lower RR categories is the result of a number of dynamics that existed in the market prior to mid-2007, as well as factors specific to the current economic downturn. Prior to mid-2007, extremely loose credit conditions fuelled unprecedented growth in the leveraged loan market and resulted in 'top-heavy' debt structures on speculative grade company balance sheets. Strong demand led to increasingly aggressive lending practices, including a significant deterioration in the quality of covenant packages in bank loan agreements, and the introduction and broad acceptance of covenant-lite loans.

As the US economy began to sink into recession in 2008, corporate credit fundamentals began to deteriorate significantly. This in turn led to shrinking enterprise values due to lower EBITDA multiples and declining asset values, which have a negative impact on RRs and may subsequently have a negative impact on actual recoveries.

Fitch anticipates that the combination of lower enterprise valuations and higher percentages of senior secured loan in corporate debt structures will lower recoveries for both secured and unsecured creditors in the future, and these expectations are incorporated into our recovery ratings. The future direction of RRs will be largely dependent upon the timing and strength of an economic recovery and a further loosening of the currently tight credit markets.

Although the agency believes RRs in general will continue to trend lower in the near term, several market indicators may point to at least a slowing in the rate of deterioration in RRs. These include the increase in loan refinancings in recent months with the proceeds from high yield bond issues, the large number of amendments to bank credit agreements and the increase in debt exchanges.

Through to 11 June 2009, Fitch estimates that over US$55bn of new high yield bonds have been successfully issued in the public bond market this year, with US$24.3bn being issued during the month of May alone. This could be critical to providing companies with the capital they need to refinance their maturing loans and to provide the liquidity needed to survive the current economic recession.

Leveraged loan maturities are estimated at approximately US$130bn in 2010, increasing to US$255bn in 2011. The fact that companies are refinancing their loans with bonds should result in a shift toward more normalised corporate debt structures - that is, more unsecured debt and less secured debt. In turn, this should cause recovery rates on leveraged loans to improve, Fitch concludes, since there will be less such debt with a priority claim on the company's enterprise value.

Ratings

Lehman-related CSO ratings withdrawn

S&P has withdrawn its ratings on 104 synthetic CDO tranches that have counterparty exposures to Lehman Brothers Holdings Inc. The affected CDOs span globally, comprising eight in the US, 45 in Europe, one in Japan and 50 in Asia-Pacific (excluding Japan).

Following the default of Lehman Brothers, S&P has sought to obtain updated information on these deals from transaction participants, including if any termination event had been called or if any final payment report had been issued. To date, the agency has received limited or no information that it considers to be meaningful.

S&P says it has taken several rating actions over the past few months based on the limited information it has received. The ratings on most affected transactions have remained on watch with negative implications, reflecting the limited available information.

The agency believes that it is unlikely any further information will become available within the foreseeable future to enable it to continue to provide credit opinions on these transactions. Given these limitations, S&P has withdrawn the outstanding credit ratings assigned to the relevant transactions.

Ratings

Other rating agency actions

SME ABS performance deteriorates
S&P placed its ratings on 52 classes from various small business securitisations originated in 2005, 2006 and 2007 on watch with negative implications. The rating action, which affects 12% of the agency's rated outstanding small business loan securitisation debt, follows S&P's review of all outstanding 48 small business securitisations.

Credit performance for several Lehman Brothers Small Balance Commercial Loan Trusts, Business Loan Express Business Loan Trusts and Business Loan Express SBA Loan Trusts has been deteriorating, as evidenced by rising delinquencies, increased default frequencies and longer recovery periods, S&P notes. The current economic stresses seem to be having the greatest impact on delinquency rates, but they are also affecting the timing in which the transactions recognise recoveries. The negative watch placements reflect the agency's lower-than-expected recovery assumptions for these transactions.

As part of the analysis, S&P ran updated loan tapes (loan details on the obligor level) through its Small Business Portfolio Evaluator using updated 2009 SBA industry default data. Since the 2009 data captures more of the recent stressful environment, the expected default rates have subsequently increased as well.

Synthetic CDOs hit
S&P has placed on watch negative its credit ratings on 79 tranches issued from 19 CDO transactions. These rating actions are due to deterioration in the credit quality of the underlying portfolios in these deals. The agency has also observed par value losses following the default of portfolio holdings in some of the affected CDOs.

In S&P's opinion, portfolio credit deterioration and par losses increase the risk that cashflows may not be sufficient to fully repay all rated classes, putting downward pressure on the ratings. In determining whether to place a CDO tranche rating on watch negative, S&P considers a number of factors, including the percentage of assets (including any change to this) rated below single-B minus based on its analysis, and the percentage of defaults already in the portfolios.

ABS CDOs downgraded
S&P has lowered its ratings on 21 tranches from nine US cashflow and hybrid CDOs. At the same time, the rating agency has removed five of the lowered ratings from credit watch with negative implications. It has also placed 13 ratings from Putnam Structured Product CDO 2001-1 on credit watch with negative implications.

The CDO downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US subprime RMBS. The credit watch placements primarily affect transactions for which a significant portion of the collateral assets currently have ratings on credit watch with negative implications or have significant exposure to assets rated in the triple-C category.

The 21 downgraded US cashflow and hybrid tranches have a total issuance amount of US$5.1bn. Four of the nine affected transactions are mezzanine SF ABS CDOs. The other five transactions are high grade SF ABS CDOs that were collateralised at origination primarily by triple-A to single-A rated tranches of RMBS and other SF securities.

Regulation

Reform agenda unveiled

As expected, the Obama administration's financial reform proposals are set to have far-reaching consequences for the securitisation (see separate News Analysis) and OTC derivatives markets. The plans for OTC derivatives build on earlier announcements (SCI passim), but have sparked concern regarding their appropriateness for all asset classes.

In a letter to US Treasury Secretary Timothy Geithner, Reval ceo and co-founder Jiro Okochi, writes that he "understands and agrees with the need to better regulate the over-the-counter derivatives marke, and that better transparency, controls and the ability to clear OTC derivatives would help prevent future systemic risk". However, he points out that the broad regulatory reform suggested for all OTC derivatives - despite their intended use - may in fact increase risk into the system.

According to Okochi: "A decrease in the use of OTC derivatives by companies who are true hedgers of business risk - those not likely to be a cause of systemic risk, past or future - may occur because the cost of margining and reporting would be too high. Consequently, any proprietary hedging strategies that would provide a competitive business advantage would be lost."

In particular, the proposals urge regulators to ensure that customised OTC derivatives are not used solely as a means to avoid using a central counterparty. A suggested way of achieving this is to increase regulatory capital requirements on OTC derivatives that are not centrally cleared for all banks and bank holding companies.

Additionally, the markets should be made more transparent by amending the CEA and securities laws to authorise the CFTC and the SEC to impose recordkeeping and reporting requirements (including an audit trail) on all OTC derivatives. Certain of these requirements should be deemed to be satisfied by either clearing standardised transactions through a CCP or by reporting customised transactions to a regulated trade repository.

CCPs and trade repositories will be required to make aggregate data on open positions and trading volumes available to the public and make data on any individual counterparty's trades and positions available on a confidential basis to the CFTC, SEC and the institution's primary regulators.

ISDA ceo Robert Pickel says: "The Association and our more than 800 members are gratified that these regulatory proposals acknowledge the benefits of privately negotiated derivatives, and will continue to enable companies to use these risk mitigation tools to manage their risks. We intend to continue our dialogue with the Administration, Congress and regulators to ensure that companies have the ability to custom tailor risk management solutions to meet their individual needs."

Regulation

ISDA responds to Turner Review

ISDA has submitted a letter to the FSA regarding the Turner Review and accompanying Discussion Paper (DP), which outlines a possible regulatory response to the global banking crisis. The association believes that while the Review's recent regulatory proposals have merit, there is little coverage in the Review or the DP as to the aggregate impact of adopting the proposed policies in combination.

Robert Pickel, executive director and ceo of ISDA, says: "ISDA agrees with much of the analysis presented in the Review as to the causes of the financial crisis. However, a stronger regulatory framework is just one aspect of the response to the crisis."

In addition, the association believes that proposed policy options require international agreement, such as higher capital requirements, definition and calibration of a leverage ratio, and supervisory arrangements. It believes that it is crucial that the regulatory consequences for the UK financial sector be considered in a broader context.

ISDA proposes that the FSA, in making its recommendations, should take into account the benefits of having a major financial sector, incorporating active trading markets, based in the UK. The association's response also outlines the benefits of CDS trading activities and innovation in the financial markets, including providing essential risk management tools to help reduce the costs of doing business, and warns against impairing this activity. Also, while ISDA is supportive of certain capital reforms, including the Basel Committee's focus on strengthening the trading book capital charge - provided that any resulting rise in capital requirements is reasonable and is introduced over an appropriate timeframe - it also points out that there are nonetheless categories of risk for which additional capital is not the most effective mitigant, and cautions against inappropriate application.

The Turner Review largely restricts its analysis of the role of collateral to that posted in OTC derivative contracts, but a more thorough analysis of the financial markets would uncover a widespread use of contractual provisions for collateral usage, ISDA notes. The increase in margins and haircuts on a whole range of assets, not just OTC derivatives, contributed to procyclicality in the financial system. In this context, the Counterparty Risk Management Policy Group recommends a 'paradigm shift in credit terms', urging market participants to establish haircuts and initial margins that are stable over the credit cycle - a recommendation that ISDA supports.

Pickel says: "The industry is making substantial and ongoing improvements in the key areas of the OTC derivatives infrastructure. These include the increased standardisation of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum toward central counterparty clearing, enhanced transparency and a more open industry governance structure."

RMBS

Granite has highest exposure to negative equity

Some 15% of mortgage loans by value in UK prime RMBS master trust programmes are in negative equity, according to a new report from Fitch. The agency expects that figure to increase to 34% if house prices fall in line with Fitch's expectations of a 30% house price decline peak to trough, which would mean a further 14% fall from today's values.

Fitch reports that among master trust programmes there is a wide variation of exposure to negative equity. Up to the end of April 2009, using the Nationwide Building Society (NBS) House Price Index, the agency estimates that Northern Rock's master trust RMBS programme Granite, with 32% of loans (by value) in negative equity, has the highest proportion and Barclay's Gracechurch pool, with only 2% of loans in negative equity, has the lowest proportion. These significant relative differences will persist if house prices fall further.

Northampton, Nottingham and Derby are the worst affected cities. Fitch's analysis shows that the East Midlands has the highest proportion of loans in negative equity (21.8% by value and 15.1% by number of borrowers) and Scotland has the lowest (5.4% by value and 3.6% by number of borrowers).

"Amongst the loans in our analysis, which constitute nearly 25% of all outstanding UK prime mortgages, approximately 270,000 borrowers are in negative equity," says Alastair Bigley, head of RMBS for UK and Ireland at Fitch. "Of the 2.7m prime mortgage loans totalling £263bn securitised through RMBS, more than £39bn of loans are in negative equity and this figure will rise further as house prices continue to fall."

Such an increase in isolation is unlikely to result in negative rating action, since a 30% peak-to-trough house price decline is already factored into current Fitch RMBS ratings.

"While prime borrowers are unlikely to default solely because the value of their house is less than the outstanding balance of their mortgage, Fitch expects default rates to be higher for borrowers in negative equity," says Ketan Thaker, director in Fitch's European RMBS team. "Borrowers with equity in the property have options available to them in case of financial distress that borrowers in negative equity do not; for example, sale of property, remortgaging, better availability and pricing of products, and the withdrawal of equity to fund temporary cash shortage, which could help avoid foreclosure."

RMBS

Dutch RMBS downgraded as EOD looms

Moody's has downgraded the ratings of all the notes issued in Dutch RMBS E-MAC 2002-I and the non-senior notes issued in the E-MAC 2003-I and E-MAC 2003-II transactions. The downgrades result from specific structural features of the affected transactions, which the agency believes may affect the likelihood of an event of default (in E-MAC 2002-I) and the severity of potential losses to noteholders after the notes are subject to a step-up of interest.

The ratings of all the notes in these three transactions and those of the 14 other Dutch E-MAC transactions issued prior to April 2008 remain on review for possible downgrade.

According to Moody's, a step-up of interest will occur if the notes remain outstanding after the relevant put option date. All the Dutch E-MAC transactions are subject to a similar put option process and interest step-up mechanism. Moody's, however, believes that not all of them are exposed to the same credit risks as the affected transactions, due to different structural features.

In all of the Dutch E-MAC transactions, noteholders have the option to put their notes to the issuer on predefined dates. Note redemptions under this put option would be funded by a servicer advance to be provided by GMAC RFC to the issuer.

Because of its optional nature, this feature is not reflected in Moody's ratings. Accordingly, the downgrades do not reflect the probability that GMAC RFC will or will not be in a position to provide this servicer advance or that the issuer will be able to make timely payment to investors who exercise their put options. Pursuant to the transaction documents, the failure of the issuer to redeem notes put by investors would not constitute an event of default.

If any of the notes are not redeemed on the put option date, the interest rate on these notes will be subject to a step up. Because this step-up interest is calculated with reference to market prevailing rates, it could be significantly higher than the current interest rate level.

The step-up component of the interest on the notes (referred to as the extension margin and unrated by Moody's) is deeply subordinated in the waterfall. However, in the E-MAC NL 2002-I transaction, a missed payment on this component in relation to the senior Class A notes could lead to an event of default, which could potentially lead to an acceleration of the notes.

In addition, in that transaction as well as in the EMAC NL 2003-I and 2003-II deals, in a post-enforcement scenario, the step-up component of the interest on each class of note would rank higher in the priority of payments than the interest and principal on more junior notes, which could affect the severity of losses on these notes. Moody's took these structural features into account when determining the magnitude of the downgrades on the three affected transactions. Based on information available at this point, the agency expects to conclude its rating review on or around 1 July 2009. If suitable back-up agreements are not executed by that date, Moody's expects to downgrade all the ratings of the transactions under review. The magnitude of the downgrade would reflect Moody's analysis of the possible consequences of a cash management disruption, which could result in the inability of the issuer to allocate available funds when payments become due and lead to principal or interest payment defaults and losses.

In sizing these potential losses, Moody's would take into account the exposure of the notes to the unwinding of interest rate or currency exchange hedges following termination events that could be prompted by missed payments under the swaps.

Finally, as part of the put option process, Moody's anticipates that it will be requested to affirm its current ratings on all the notes of the Dutch E-MAC transactions on or about the put option date and that similar requests will be made to the other agencies rating these transactions. The inability of any of these agencies to comply with such requests may lead to a mandatory redemption of all the notes in the Dutch E-MAC transactions, which could lead to an enforcement process (and, in that scenario, to a potentially higher severity of losses on junior notes due to the step-up interest ranking higher on more senior notes, for the three affected transactions).

There is no certainty that Moody's or other rating agencies will be able to comply with this request and Moody's ratings are consistent with this uncertainty, as well as with the possible consequences of the structural features of the affected transactions in a mandatory redemption scenario. However, with respect to principal payments, Moody's ratings address the ultimate payment at par on or before the rated final legal maturity date and not the likelihood of timely payments under a mandatory redemption.

Structuring/Primary market

Discover shores up credit card trust

Discover has taken various steps to shore up its Discover Card Execution Note Trust (DCENT), according to ABS analysts at Deutsche Bank. The bank increased the level of credit enhancement available by 6.5% through the issuance of a Series 2009-CE, a retained US$600m Class D note. It also issued a Series 2009-SD note in an amount equal to 2% of the aggregate investor interest of the trust.

The retained 2009-SD will be able to allocate all of its principal collections to cover trust shortfalls. Discover will also begin to allocate a proportionate share of interchange to the Series 1996-4, 2003-3 and 2003-4 notes, which were not structured to receive interchange allocations previously. The remaining 14 series in the trust already receive interchange allocations.

Meanwhile, the June performance report for the Washington Mutual Trust reflects an improvement in performance, following the mass substitution of Wamu credit card receivables in the trust with JP Morgan Chase receivables. The Trust's charge-off rate declined sharply from 13.14% to 2.84%, while one-month excess spread rose from 0.05% to 10.40%. Three-month average excess spread now stands at 3.86%, up 199bp from last month's level.

Technology

IDC to provide fair value data reports

Interactive Data Corporation's pricing and reference data business has broadened its evaluated services capabilities for clients. The firm has launched a new monthly market data report to help clients prepare for fair value measurements under FAS 157-4.

The standard provides additional guidance to preparers of financial statements for determining when the volume and level of activity for an asset or liability have significantly decreased and for identifying transactions that are not orderly. Interactive Data responded to FASB's request for comments to the proposed FSP FAS 157-e, which was adopted as FSP FAS 157-4.

Interactive Data's monthly market data report contains information regarding market activity in different asset classes, including US corporate bonds, municipal bonds and ABS/MBS. A key tenet of the firm's evaluations process is to review market information and identify activity that may not be indicative of orderly transactions.

In addition to the monthly market data report, clients can also now submit and track evaluation inputs requests online via Interactive Data's 360View service. With 360View, they can also review key assumptive data used in the evaluation process for structured securities, including CMOs, ABS and CMBS.

The firm has also expanded its evaluations capabilities by adding new coverage for MBS, including 18 new pool types.

Trading

Trading ideas: no deficit here

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on CA Inc

The bond market has entered a period of revival as cash products outperformed synthetic counterparts. Even with the compression of the bond-CDS basis on a market-wide level, opportunity remains with select issuers to buy bonds hedged with CDS.

Though we have held a bullish view on CA Inc credit all year, we believe its 6 1/8s of December 2014 bond will outperform its CDS. The negative basis between the two instruments is 162bp, which is substantially larger than the average.

The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond - and thus is paid to take credit risk on the issuer - while paying for credit risk in the CDS market by buying protection on the issuer.

There are many drivers of the basis, both technical and fundamental. Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor earns positive carry because the credit spread that is collected in the cash market is greater than the spread that is paid in the CDS market.

Based on our valuation approach, the CA Inc 6.125 of December 2014 bond fair value is US$107.90. Exhibit 1 compares the bond z-spreads with the CDS term structure and shows that the recommended bond is indeed trading wide of the closest-maturity CDS with a basis of -162bp.

Exhibit 1

The position is default-neutral. There is a slight maturity mismatch because the bond matures on 1 December 2014 and the CDS expires on 20 June 2014, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

CA's CDS is trading at 102bp, which is around 30bp wide to fair value, according to our MFCI (directional credit) model. The model uses both market-implied and fundamental factors to calculate an expected spread relative to other non-financial credits. With a large and stable market cap, minimal debt due, strong cash balance, and solid margins and interest coverage, we believe CA is a decent candidate for an outright long credit position using CDS.

As Exhibit 2 shows, we have been bullish on CA all year. However, the differential between CA's expected and actual spread is fairly low now and therefore we believe the bullish view can be better expressed through a negative basis trade with its 6 1/8s of Dec 2014 bond.

Exhibit 2

The bond (assuming a price of US$100.25) trades with a z-spread of 272bp (Exhibit 2). The negative bond-CDS basis is then 162bp.

Currently, the average technology basis in our liquid universe is only -24bp. There is solid potential for the bond to outperform its CDS.

Position
Buy US$10m notional CA Inc. 5 Year CDS protection at 103bp.

Buy US$10m notional (US$10m proceeds) CA Inc. 6.125s of December 2014 at US$100.25 (T + 324bp; z-spread of 272bp) to gain 169bp of positive carry.

The appropriate interest rate is dependent on the portfolio in which the trade is held. Customised rate hedge information is available upon request.

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).