News Round-up
Structured ARS impacted
A round up of this week's structured credit news
Structured ARS impacted
An estimated US$5bn to US$10bn of structured auction-rate securities (ARS) held by institutional investors are expected to be impacted by the combined failures of Fannie Mae, Freddie Mac and Lehman Brothers.
According to Brian Weber, senior analyst at Houlihan Smith & Co, three types of structured ARS could be affected by technical triggers related to events of default of Fannie Mae, Freddie Mac and Lehman CDS. "First, ARS issued as CLNs referencing CDS indices could be wiped out if certain defaults occur - and these three names were widely referenced by index tranches," he explains.
The other two types of ARS are those issued by Lehman itself, backed by Fannie and Freddie preferred stock (which is now worth somewhere in the region of 5c on the dollar), or backed by MBS. "These structures weren't originally considered to be too risky, but the anticipated sell-off of Lehman assets is likely in general to depress MBS prices even further - thereby impacting ARS backed by MBS," continues Weber.
However, whether these developments lead to further litigation in the ARS space depends on if the structures were sold under the guise of their being safe, money market-like instruments.
ISDA outlines protocol plans
ISDA has announced it plans to launch a number of protocols created to facilitate the settlement of credit derivatives trades involving Tembec Industries, Fannie Mae and Freddie Mac.
The first protocol involves Tembec Industries, an integrated Canadian forest products company that has filed a Chapter 15 petition in the US as a final step in its recapitalisation. The Protocol is open to ISDA members and non-members alike, with the adherence period running from 17 September to 22 September 2008.
The 2008 Tembec CDS Protocol permits cash settlement of single-name, index, bespoke tranche and other high-yield credit derivative transactions. Markit and Creditex will administer the auction, scheduled for 2 October 2008, which will determine the final price for Tembec Industries bonds.
ISDA has also announced a further step toward completion of its protocol for credit derivative transactions referencing Fannie Mae and Freddie Mac. After consulting with a broad section of its membership as to the deliverability of the principal-only component of debt securities of the two GSEs, ISDA consulted its Board of Directors to bring the debate to resolution. The ISDA Board, with the benefit of advice from Allen & Overy that any component of a debt security is not a deliverable obligation under a standard CDS contract, determined that principal-only components will not be included in the list of deliverable obligations for purposes of the settlement auctions in respect of the GSEs.
ISDA expects to publish the list of deliverables, along with a draft protocol for Fannie Mae and Freddie Mac CDS, in the coming week. Due to the large number of obligations that might be identified as deliverable obligations for purposes of the auction settlement mechanism, the Association and market participants believe it prudent to establish a process for identifying such deliverable obligations.
ISDA says it is also working with all constituents across the industry to realise swift and smooth resolution in closing out bilateral derivatives positions in which Lehman Brothers Holdings is either a counterparty or reference entity. The Association expects the following procedures to apply in relation to such transactions:
• Where a market participant is facing a Lehman group entity as counterparty on an OTC derivative trade, whatever the underlying asset class, participants are expected to refer to the Master Agreements and Credit Support (collateral) documentation that they have in place covering OTC derivative transactions with one or more Lehman group entities and take advice from legal counsel as appropriate. Where participants determine that an event of default has occurred with respect to their counterparty, the terms of this documentation will allow participants to take bilateral action to: i) close out contracts; ii) determine the net amount owing between them; and iii) take into account any collateral that may have been posted. Parties are expected to determine when and how to put these provisions into practice, working with their legal counsel as appropriate.
• Where a Lehman group entity is the subject of a credit derivative trade, a decision has been made to hold an auction with respect to covered credit derivatives transactions that reference LBHI. ISDA will perform its usual role in relation to such auction. This process will follow the usual timeline, involving market participants in all the stages that normally apply in effecting a protocol.
Lehman impact assessed by Fitch ...
Fitch says it is currently assessing the potential ratings impact of the bankruptcy of Lehman Brothers Holdings (LBHI) on synthetic CDOs that it rates. Following LBHI's declaration of bankruptcy, the agency downgraded the issuer default rating (IDR) and debt ratings of LBHI and its parent, along with other subsidiaries. These downgrades are expected to adversely impact the ratings of synthetic CDOs whose credit quality is linked in some way to that of Lehman-related entities.
The participation of the Lehman entities expected to impact CDO ratings can be divided into two main categories: instances where Lehman provided credit support to the CDO, either as a CDS counterparty or as a charged asset; and instances where Lehman's debt was referenced as part of the CDO portfolio. Lehman acted as swap counterparty in 69 Fitch-rated synthetic CDOs - 31 in Europe; 35 in Asia; and three in the US. The impact on CDO note ratings where a Lehman entity acts as swap counterparty will depend upon many factors, including whether the CDO transaction faces an automatic unwind following the Lehman bankruptcy, whether the swap may be transferred to another counterparty and the extent to which noteholders may be subject to market value risk of eligible securities in the event of early termination of the transaction.
Fitch expects early termination events to be triggered for most transactions where LBHI acts as swap counterparty or credit support provider unless a replacement counterparty is found within the required time period (usually 10 to 30 days). If an early termination is triggered where the swap counterparty is the defaulting party, the eligible securities are typically liquidated and used to repay the CDO notes before any swap termination payment is potentially due to LBHI.
In these instances, the CDO noteholders' risk profile may shift from the portfolio of reference entities to the liquidation of the eligible securities. The CDO noteholders will either be paid in full from proceeds of the eligible securities, or will incur a shortfall if liquidation of the eligible securities results in a market value loss that is not offset by any overcollateralisation and collateral posting requirements of the transaction.
Additionally, Lehman debt instruments are eligible securities, or collateral, to four Fitch-rated funded synthetic CDOs and the agency expects to downgrade notes exposed to Lehman entities as the charged asset to triple-C or single-D.
Finally, Lehman-related debt is referenced in the portfolios of approximately 150 Fitch-rated synthetic CDO. LBHI was the 41st most referenced entity, appearing in approximately 25% of the portfolios of synthetic CDOs rated by Fitch.
The impact of the bankruptcy and downgrade of Lehman is expected to have a much smaller impact on these transactions, as individual entities typically account for between 0.5% and 2% of the overall portfolio. The extent of impact on individual CDO ratings will depend upon the exposure to Lehman relative to the transaction's remaining credit enhancement, the extent of recoveries on the defaulted debt and the remaining term of the transaction.
... and Moody's
Moody's downgraded Lehman Brothers' senior ratings, as well as those of certain guaranteed subsidiaries, to B3 under review for further downgrade from A2. The short-term ratings for all rated Lehman entities were lowered to Not-Prime from Prime-1.
The agency says it is presently assessing the impact of Lehman's bankruptcy and rating downgrade on all structured finance transactions that have exposure to Lehman entities. Lehman entities provide credit and/or liquidity support to such structured finance transactions through one or more of the following roles:
— counterparty under derivatives contracts;
— liquidity provider;
— repo counterparty;
— tenant;
— guarantor;
— expense provider in multi-issuers.
These and other structured finance transactions may be exposed to operational and/or credit risk through one or more of the following roles:
— servicer or back-up servicer;
— sponsor;
— cash manager;
— custodian;
— paying agent;
— remarketing agent;
— calculation agent;
— collateral manager.
In addition, structured finance transactions may be exposed to Lehman by reason of holding debt instruments issued by Lehman entities or where the bank is named as a reference entity under CDS.
The asset classes and issuers most likely to be affected by exposures to Lehman entities include:
— asset-backed securities;
— residential and commercial mortgage-backed securities;
— asset-backed commercial paper;
— CDOs;
— repackaged securities;
— CFOs;
— leveraged super-senior obligations;
— derivative product companies; and
— constant proportion debt obligations.
Moody's expects to release further statements and/or rating actions for specific regions, asset classes and transactions in the near future. The agency notes that each transaction will be assessed based on the specifics of its structure and its performance.
Fed provides additional support
The Federal Reserve Board has announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.
"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," says Federal Reserve Board chairman Ben Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."
"We have been and remain in close contact with other US and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," he adds.
The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.
The collateral for the Term Securities Lending Facility (TSLF) has also been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities and triple-A rated mortgage-backed and asset-backed securities could be pledged.
These changes represent a significant broadening in the collateral accepted under both programmes and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally, the Fed says.
Additionally, Schedule 2 TSLF auctions will be conducted each week; previously, they had been conducted every two weeks. The amounts offered under Schedule 2 auctions will be increased to a total of US$150bn, from a total of US$125bn.
The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on 30 January 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.
Index rolls postponed, LATAM index prepped
Following a majority dealer vote, Markit index rolls have been delayed by a week. At the same time, Markit has announced that it plans to launch a new Latin America corporate-only synthetic index, the CDX LATAM.
The new index will be comprised of 20 equally-weighted reference entities from Brazil, Mexico, Argentina, Chile and Venezuela. Additional details, such as rules and trading documentation, will be made available at a later date.
The Markit CDX.NA.IG, NA.XO, EM and EM Diversified indices will roll on 29 September, while the NA.HY index will roll on 6 October 6. The iTraxx European IG and XO indices, as well as iTraxx Asia, Japan, Australia and LevX will also now roll on 29 September. Markit says that the decision to call a vote was prompted by the exceptionally high trading and clearing activity observed in CDS markets on 14 September.
FASB issues FSP
The Financial Accounting Standards Board (FASB) has issued FASB Staff Position (FSP) No. 133-1 and FIN 45-4, 'Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161'. The FSP is intended to improve disclosures about credit derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance and cashflows of the sellers of credit derivatives. It amends FASB Statement No. 133, 'Accounting for Derivative Instruments and Hedging Activities', to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments.
Over the past few years, credit default swaps have become the most dominant product of the credit derivatives market. They also have become the focus of attention for both market participants and regulators because of the turmoil in credit markets during 2007 and 2008.
During this period, some sellers of credit derivatives have seen a large number of obligations that are referenced in credit default swaps facing actual or potential defaults, resulting in large liabilities and/or potential credit downgrades. The FSP addresses concerns of financial statement users that the disclosure requirements in Statement 133 do not adequately address the potential adverse effects of changes in credit risk on the financial statements of the sellers of credit derivatives.
The FSP also amends FASB Interpretation No. 45, 'Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others', to require an additional disclosure about the current status of the payment/performance risk of a guarantee. This amendment of Interpretation 45 reflects the Board's belief that instruments with similar risks should have similar disclosures.
The provisions of the FSP that amend Statement 133 and Interpretation 45 are effective for reporting periods (annual or interim) ending after 15 November 2008.
Finally, the FSP clarifies the Board's intent about the effective date of FASB Statement No. 161, 'Disclosures about Derivative Instruments and Hedging Activities'. In deciding on the effective date for Statement 161, the Board intended that entities begin providing the additional disclosures for the first reporting period beginning after 15 November 2008. However, the use of the terms fiscal years and interim periods in paragraph 7 of Statement 161 has raised questions about whether the disclosures are required in the 2009 annual financial statements for entities with non-calendar year-ends, because an annual report generally does not include separate financial statements for the Q4 interim period.
Accordingly, the FSP clarifies that the disclosures required by Statement 161 should be provided for any reporting period (annual or quarterly interim) beginning after 15 November 2008. For example, an entity with a 31 March fiscal year-end should provide the disclosures for its Q4 interim period ending 31 March 2009 in its 2009 annual financial statements. This clarification of the effective date of Statement 161 is effective upon issuance of the FSP.
Permacap monthly NAVs released
Permacap vehicles Carador and Tetragon have reported their August NAV figures.
As at the close of business on 31 August 2008, the unaudited net asset value per share of Carador was €0.6817. The vehicle's NAV increased by 2.13% in August, with the calculations including an estimated €405,621.71 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0081 per share.
Meanwhile, Tetragon recorded a NAV per share of US$10.54. The company says NAV per share month-on-month movement reflects an increase of US$0.11 per share earned through TFG operations and a decrease of US$0.01 per share associated with the issuance of shares pursuant to its optional stock dividend plan on 26 August.
S&P downgrades Sigma
S&P has lowered its issuer credit and senior debt ratings on Sigma Finance Corp to single-A and A-1 from double-A minus and A-1+ respectively and removed the ratings from watch negative, where they were placed on 18 March 2008. The agency's outlook on Sigma is negative.
While S&P says it sees many positive factors regarding Sigma, the lowered ratings reflect its view of the ongoing challenges in the credit markets, the potential side effects of repo financing, the absence of new third-party capital investment and the updated results of its stress-case scenario analysis. In light of the current challenging debt market, the vehicle has become even more reliant on its existing repo agreements to help finance its current asset portfolio, which totalled more than US$27.5bn as of Sigma's 10 September report to S&P.
Sigma's current funding mix consists of approximately US$6.3bn in both US and euro medium-term notes with a maturity that extends to 2017 and approximately US$17.3bn in repurchase agreement funding. Its capital notes total approximately US$3.9bn and have maturity dates that range from 2008-2017.
S&P has been monitoring Sigma's performance in the following areas: selling assets, swapping existing debt for assets, seeking new repo financing and managing the gradual de-leveraging of its vehicle. So far, Sigma has succeeded in each of these areas.
Japanese SME CDOs stable for now
According to a new report from Moody's, Japan SME CDOs rated by the agency have in general exhibited some ratings stability so far, even though the number of defaults for SMEs in the country appears to be rising.
"One primary reason is that most of these transactions are backed by amortising loans; few are backed by bullet loans," says Daisuke Kitazawa, Moody's analyst and author of the report. "In this report we provide sample analyses - using hypothetical SME CDOs - showing how differing payment methods for underlying loans impact CDO rating stability."
The key finding is that the stability of a CDO deal backed by amortising loans differs significantly from that of one backed by bullet loans - even if all other aspects of the underlying pool are identical - when the default rate of underlying pool is rising gradually. A CDO deal backed by amortising loans shows greater robustness against deterioration in its underlying SME credit quality than one backed by bullet loans.
Relationship between CDS IR and future rating actions
Fitch Solutions has published a new study showing a strong direct relationship between CDS-implied ratings and future agency rating actions. Highlights from this research include:
• The degree of 'notch differential' between the CDS IR and agency rating can predict future agency rating actions better than 50% of the time over a one-year horizon, and better than 60% of the time over a three-year year horizon.
• CDS IR model output gave early warning signals for UBS's two recent agency rating downgrades and Hess Corporation's recent upgrade.
• The top 10 entities currently signalled as high-potential future upgrades and downgrades by the CDS IR model, including Hasbro, Loew's Corp and Sony Corp.
GSE impact on CDOs analysed by DBRS ...
With Fannie Mae and Freddie Mac comprising 1.6% of each series of the CDX.NA.IG Index (Series 1 through 10), the names are referenced in 51 and 43 transactions, respectively, out of 79 total deals, according to DBRS figures. All 43 transactions referencing Freddie Mac also reference Fannie Mae.
In analysing CDO transactions, DBRS typically applies a fixed recovery rate in the range of 30% to 40% to all underlying obligors, depending on the rating of the CDO tranche. Based on current market pricing, the agency expects that the recovery rates for Fannie Mae and Freddie Mac will be significantly higher than this assumption, mitigating the negative impact of these two credit events.
Under such a scenario, the credit events are not expected to materially impact the transactions. However, if actual recovery rates are much lower than current market indications, negative rating action may result for a number of the deals.
... and by Fitch
Credit events on Fannie Mae and Freddie Mac are unlikely to trigger large scale downgrades of CDOs, despite the fact that both GSEs are referenced in approximately 30% of synthetic CDOs rated by Fitch, the agency says. The impact on CDO ratings is likely to be muted because high expected recovery rates will not pass significant losses onto the CDO.
Fannie Mae and Freddie Mac are the seventh and 21st most popular reference entities in Fitch's synthetic CDO index, which tracks Fitch-rated European synthetic CDO reference portfolios. Either Fannie Mae or Freddie Mac are referenced in nearly 200 CDOs globally, while approximately 150 CDOs reference both names.
The CDO transactions most likely to be affected are CDO-squareds that reference the agencies in multiple portfolios, CDOs that reference the subordinated debt and CDOs with fixed recovery rates on the reference assets. CDOs that reference the subordinated debt are likely to be more adversely affected than those that reference the senior debt due to lower market value, and therefore expected recovery rate, of the subordinated debt. Approximately one-third of the Fitch-rated CDOs with exposure to at least one of the agencies reference the subordinated debt.
TruPS CDOs under pressure ...
Ongoing default and deferral activity with respect to US banks which issue trust preferred securities (TruPS) through CDOs continues to put rating pressure on bank TruPS CDOs, according to Fitch in a special report.
Since September 2007, Fitch has observed US$1.7bn of TruPS defaults, deferrals and credit risk sales across 38 banks. At present, 78 of 85 Fitch-rated bank TruPS CDOs have experienced at least one underlying asset default or on-going deferral, with exposure averaging 5.5% of the current portfolio balance and ranging from a maximum of 18% to a minimum of 0.6%.
"Outsized exposure to residential construction loans and home equity loans and high rates of growth prior to the onset of recent credit pressures, fuelled by above-average levels of TruPS issuance and/or brokered deposits, are among the factors consistent across the those banks which have defaulted or deferred on issued TruPS," says Fitch senior director Nathan Flanders. "Banks that issue TruPS through CDOs are likely to financially underperform through the first half of 2009, which could lead to additional default and deferral activity and subsequent negative rating pressure on bank TruPS CDOs."
... and downgraded
Moody's has downgraded and left on review for further possible downgrade 36 tranches, and placed additional 21 tranches on review for possible downgrade, across 14 trust preferred (TRUP) CDOs. The downgrades are prompted by the exposure of these TRUP CDOs to trust preferred securities issued by eight banks taken over by their regulators in recent months.
This rating action reflects Moody's assumption that that there will be zero recovery on the trust preferred securities issued by these banks. In addition, the agency assumes recoveries will be low on some of the other trust preferred securities currently deferring coupon payments in the collateral pools backing these securitisations. While historically many banks that have deferred payment on trust preferred securities have ultimately resumed payment, Moody's expects that many banks deferring in the current environment are unlikely to become current again.
The initiation of the additional review for possible downgrades reflects a general concern that the risk of deferrals is increasing for bank issuers of trust preferred securities. The specific TRUP CDO tranches placed on review for downgrade were selected because preliminary testing revealed their ratings could be affected by an increase in the pool-wide default probability and correlation assumptions used for trust preferred securities that are currently performing.
Rise in defaults analysed
The sharp rise in defaults in 2008 comes as no surprise, given the current lackluster economic activity and financial conditions, elevated energy prices that have sapped consumer confidence, and a markedly higher cost of capital, says an article published by S&P. In the first eight months of 2008, 55 entities defaulted globally, compared with just 22 in all of 2007 and 30 in 2006. The global speculative-grade default rate has increased to 1.9%, more than double the year-end 2007 level of 0.86%.
In the US, which accounts for 53 of the 55 defaults, the default rate increased for eight consecutive months to 2.5% in August, from a 25-year low of 0.97% at the end of 2007. "We expect the default rate to continue this ascent and reach 4.9% in the next 12 months," says Diane Vazza, head of S&P's global fixed income research group.
Ownership of the 55 defaults on which the agency could gather information reveals that, generally, large shareholders of these defaulted entities are asset management firms, alternative investment funds, endowment and pension systems, and individual stakeholders. However, the complex relationships of the players within the capital markets serve to dilute the exposure of any given group.
"Of the 55 defaults, nearly 70% were involved in transactions involving private equity at one point or another, which may or may not have facilitated the default," adds Vazza.
Liquidated CDO ratings withdrawn
Moody's has announced that it has withdrawn the ratings of 261 classes of notes issued by 34 CDOs backed primarily by portfolios of RMBS securities and CDO securities because they have completed liquidation following events of default.
SROC results for Europe
After running its month-end SROC figures, S&P has taken credit watch actions on 116 European synthetic CDO tranches. Specifically, ratings on 109 tranches were placed on credit watch with negative implications; two tranches were placed on watch negative following their removal from watch positive; and five tranches were removed from watch negative and affirmed.
Of the 111 tranches placed on watch negative, 46 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 65 have experienced corporate downgrades in their portfolios.
Further CPDOs under review
Moody's has put under review for possible downgrade the ratings of 10 series of CPDO notes, both static and managed transactions. The deals affected by the action are Castle Finance II Series 2, Thebes Capital Series 2006-1, Artemis DPI Series 2007-1 and 2, SEA CDO Series 2007-2, RIDERS 2006-3 and 18, RECIPES Series DE, Arlo X Series B-1Z and Coriolanus Series 92.
These actions are based on the following:
• The placement of Fannie and Freddie in conservatorship on 8 September 2008,
• Lehman Brothers Holding's filing for bankruptcy on 15 September 2008, and/or
• A substantial increase in markets spreads, which negatively impacts the performance of CPDOs.
Calypso improves Fast-Track
Application software provider Calypso Technology has announced enhancements to its Calypso Fast-Track offering. Launched in 2007, Calypso Fast-Track is a pre-configured application environment designed to expedite deployment of Calypso's trading, risk and operations application. The second generation includes enhanced accounting, reporting and additional instruments and currencies.
Because Calypso Fast-Track provides a pre-configured solution, customers are able to quickly realise the benefits of how Calypso's front-to-back, cross-asset solutions work within their enterprise. The offering also comes with full documentation and corresponding training courses to address any configuration issue. Customers can utilise the training to help teams and new hires quickly get up to speed on Calypso's trading and risk management system.
Rhinebridge makes cash distribution
The receivers of SIV-lite Rhinebridge made a cash distribution following a partial redemption of the USCP and ECP notes earlier this week. The portfolio sale distribution, which amounted to US$14m, was insufficient to fully repay the senior obligations. It was also insufficient to allow any payment to be made to the holders of the capital notes or any other party subordinate to the senior creditors.
The receivers, Deloitte, made the portfolio sale distribution by paying each senior creditor a pari passu amount in respect of its payable pre-distribution senior obligations. In the case of USCP and ECP notes, amounts paid to holders have been paid pari passu between the unpaid redemption price of each USCP and ECP note and the ongoing interest which has accrued in respect of the redemption price.
17/09/2008
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