It's looking more likely that the credit derivative product company (CDPC) Athilion Capital Corp. will be downgraded over the short term. Until now, CDPCs had been relatively unaffected by the credit crunch, but the latest action on Athilion will bring this sector under the spotlight.

Moody's Investors Service last week announced that it had put the triple-A counterparty and debt ratings of this CDPC on review for downgrade. This follows Fitch Ratings' announcement earlier in the month that it had placed the CDPC on rating watch negative as a result of exposure to structured finance CDOs for which Athilon sold protection to counterparties. These transactions have experienced significant negative ratings migration in their underlying collateral assets.

Athilon had the ability to add structured finance exposure to its portfolio and had written CDS on two SF CDO tranches.

The smaller of these transactions, which is rated by Fitch, has experienced meaningful negative ratings migration, with the rating of the most senior tranche downgraded to 'CCC' from 'AAA'. The second transaction, which is not rated by Fitch, has also experienced recent negative ratings migration in its underlying assets.

As a result of the increased credit risk, Athilon's capital may be insufficient to limit expected losses to levels commensurate with its current ratings. The remainder of the portfolios comprised static bespoke tranches referencing corporate and sovereign entities, said Moody's.

"Moody's has followed up with the same ratings view, which means that the company will likely get downgraded at some point," said John Schofield, an RBS Global Banking & Markets analyst.

However, he added that it still remains to be seen how severe the downgrade will be, and in the event of a severe downgrade, the entity would be placed into a "suspension" mode, which allows a period of time for capital to be rebuilt. If that doesn't work, then a "wind down" mode takes over, turning the vehicle into a static CDO squared until maturity. In any event, an unwind of the vehicle's transactions is not necessary.

Normally, CDPCs run prospective trades through the capital model. They can trade as long as the rating is not threatened. If the model subsequently fails for any reason, the CDPCs enter "suspension" mode, which is like a grace period allowing the failure to be fixed. If it is not fixed, then CDPCs wind down and turn into static transactions, which cannot be reversed.

Schofield added that it's unlikely that this latest rating action will have a trickle effect on other CDPCs, which RBS estimates have written protection in the region of $100 billion. The only other CDPC with structured finance exposure is Primus, which has just 0.3% of its total exposure in the asset class. Most of the others do not have a structured finance mandate, Schofield said.

The companies are a fairly new development in Europe, although Schofield said that they are more global in nature and aren't really geographically restricted. The first three CDPCs were U.S. based - Primus, Athilon and Invicta. Since 2007, they've been split between U.S. and Europe. Last year saw the launch of the first European CDPC via Channel Capital for the newly established asset management firm, Channel Capital Advisors. The CDPC was set up by Channel Capital Advisors and a consortium of commercial banks including Calyon, KBC Financial Products and LBBW.

Also, each CDPC would invest in a geographically diverse pool of risk. "There is no reason why a U.S.-based company wouldn't invest in European tranches," he explained.

Up to last year, the number of expected transactions looked promising, with at least 10 deals in the pipeline. In recent years, there had been an increase in requests to rate new CDPC vehicles, said Katrien van Acoleyen, managing director at Standard & Poor's.

However, the liquidity crunch that has stalled most developments in the European structured finance market means that banks have become increasingly reluctant to deal with non-collateral-posting counterparties, including CDPCs. CDS written by CDPCs do not need to be collateralized.

"We saw an increase in requests to rate CDPCs before the downturn but now no one is moving forward quickly and the market conditions are extremely challenging for people trying to get new products off the ground," van Acoleyen said. "We have not started to work on new vehicles over the last year in Europe."

According to Moody's, the currently wide CDS spreads and diminished monoline competition mean that CDPCs may be strategically well placed to capitalize on prevailing market weaknesses. Limited CDS trading activity and rising corporate defaults have offset these advantages in the first half of the year and could continue to do so.

S&P said that one of the reasons these companies are so often compared to monolines is that they are engaged in similar activities, namely selling credit protection. They had, as a result, faced difficulties convincing derivative counterparties that they do not have the same risk as monolines. Schofield explained that CDPCs have more rules and safety checks and can be thought of as a more focused monoline, or like an unfunded SIV.

CDPCs are also lower levered than monolines, Schofield said, with a typical target in the region of 20x to 50x capital, compared to as high as 80x to 100x for the monolines. Many of the new CDPCs are currently underlevered due to the difficulty in getting transactions done in past months.

"One additional problem that the newer CDPCs may face is a lack of new business," Schofield said. "If an entity has issued debt as part of its capital raising but then cannot write CDS due to banks shunning non-collateral-posting counterparties, then (equity) capital may need to be depleted to pay the debt's spread."

"I don't think we'll see any this year," Schofield said. "Moody's said there were 10 in the pipeline, but these can take up to a year to put together."

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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