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A round up of this week's structured credit news
Downgrade shock
S&P has placed on credit watch with negative implications or downgraded its ratings on 6,389 classes from US RMBS transactions backed by US first-lien sub-prime mortgage collateral rated between January 2006 and June 2007. At the same time, it placed on credit watch negative 1,953 ratings from 572 global ABS CDO and CDO-squared transactions.
In many cases, the magnitude of the sub-prime rating cuts is fairly dramatic, according to structured finance analysts at RBS – who described S&P's actions as "breathtaking".
The affected RMBS classes represent an issuance amount of approximately US$270.1bn, or approximately 46.6% of the par amount of such sub-prime mortgage loans rated by S&P during the period. The CDO classes on watch negative represent an issuance amount of approximately US$263.9bn, which is about 35.2% of S&P's rated ABS CDO and CDO-squared issuance worldwide.
The agency has completed its global review of all its rated ABCP conduits with exposure to these classes and confirms that none of its ratings on any outstanding ABCP notes will be adversely affected solely as a result of the rating actions. S&P has also completed its review of all the SIV and SIV-lite structures it rates, with regard to exposure to these US RMBS classes.
The review shows that there are nine SIVs with exposure to 133 of the affected tranches. The vast majority of the exposure is to tranches with ratings placed on credit watch. These exposures are primarily in SIVs that have restructured, defaulted already or are receiving liquidity support and, therefore, the SIVs are not adversely affected by these rating actions.
Of the five SIV-lites originally rated, only one is currently still operating and has been restructured. The review of this SIV-lite shows that there is exposure to two of the affected US RMBS classes, and the ratings are not adversely affected by these rating actions.
FGIC downgraded, more monolines on watch...
Fitch and S&P have downgraded FGIC's insurer financial strength rating from triple-A to double-A and its long-term issuer rating from double-A to single-A, with the ratings remaining on credit watch. The move is due to FGIC's not yet raising new capital or having executed other risk mitigation measures in order to meet capital guidelines.
The company has a modelled capital shortfall of more than US$1bn at the triple-A rating threshold. The existing capital deficiency, which is now believed to be approximately US$1.3bn, resulted from rapid credit deterioration in FGIC's insured portfolio, in particular: transactions backed by structured finance CDOs and direct exposure to RMBS, namely prime second-lien mortgages.
The continuation of the rating watch reflects the significant uncertainty with respect to the company's franchise, business model and strategic direction; uncertain capital markets; the company's future capital strategy; ultimate loss levels in its insured portfolio; and the challenges in the financial guaranty market overall. Fitch expects to resolve the rating watch after the agency evaluates these various qualitative factors, as well as the progress FGIC makes as far as its future capital enhancement plans. This analysis will include a review of the effectiveness of recent efforts of insurance regulators to support any industry solution.
S&P also placed various ratings on MBIA Insurance Corp, XL Capital Assurance Inc, XL Financial Assurance and their related entities on credit watch with negative implications. The ratings on various related contingent capital facilities were also affected. And Fitch has placed MBIA and CIFG back on rating watch negative, despite having affirmed them with stable outlook after they raised the capital the agency had previously required.
Meanwhile, a consortium of banks (Barclays, BNP Paribas, Citi, Dresdner, RBS, SG, UBS and Wachovia) is believed to be working on a solution to the problems faced by Ambac. Sources indicate that other consortia are working to resolve the situation at MBIA and FGIC, while there has been some speculation that one of the banks involved in discussions about Ambac is proposing a bail-out of only municipal bonds.
Elsewhere, the hope of a co-ordinated bail-out was maintained as the New York Governor Eliot Spitzer reportedly said that the plan by the state's insurance regulator was "making good progress". However, the inability to assess accurately and with confidence the likely losses the monolines will incur is a major stumbling block to finding new investors and to getting agreement on a co-ordinated bail-out by banks (see last week's issue for more).
Moody's is expected to update the market on the current status of its review of the monolines by mid- to late-February. It says its intention is to evaluate each company individually and reach conclusions when the information was available.
...as Fitch revises monoline approach...
Fitch Ratings has, in light of consensus movement towards a view of increased loss projections for US sub-prime RMBS that is now held by various market participants, updated certain modelling assumptions in its ongoing analysis of the financial guaranty industry. The agency believes it is possible that modelled losses for SF CDOs could increase materially as a result of these updated projections. The need to update loss assumptions at this time reflects the highly dynamic nature of the real estate markets in the US, and the speed with which adverse information on underlying mortgage performance is becoming available.
Fitch believes that a sharp increase in expected losses would be especially problematic for the ratings of financial guarantors – even more problematic than its previously discussed increases in triple-A capital guidelines, which has been the primary focus of recent analysis of the industry. Expected losses reflect an estimate of future claims that the agency believes would ultimately need to be paid by a guarantor. A material increase in claim payments would be inconsistent with triple-A rating standards for financial guarantors, and could potentially call into question the appropriateness of these ratings for those affected companies, regardless of their ultimate capital levels.
Fitch expects in addition to increases in expected losses, that its capital guidelines are likely to increase materially as well. An increase in both expected losses and capital guidelines would place further downward pressure on the ratings of those five financial guarantors – Ambac, CIFG, FGIC, MBIA and SCA – that Fitch has previously identified as having material sub-prime exposure within their insured portfolios (see separate monoline story). Ratings on three of these guarantors – Ambac, FGIC and SCA – were recently downgraded by Fitch, and their ratings remain on rating watch negative.
Fitch continues to hold stable rating outlooks for the triple-A insurer financial strength ratings of the operating subsidiaries of Assured and FSA, the two financial guaranty companies that avoided direct exposures to SF CDOs to a material degree. The agency, however, will continue to monitor the impact of deteriorating RMBS performance on SF CDO-related CLNs tied to FSA's guaranteed investment contract (GIC) business. While deterioration in the performance of the CLNs in FSA's GIC portfolio would not cause a direct credit loss for FSA, they could result in early withdrawal of certain GIC liabilities, which could create added liquidity requirements for FSA.
...and monoline impact on banks is analysed
Downgrades of bond insurers have prompted questions about the effect on both commercial and investment banks, according to a new S&P report. Of course, successful capital-raising efforts would eliminate the need to focus on the potential effect of downgrades on financial institutions. In the absence of additional capital, however, it is useful to think about the possible ramifications of downgrades, which could affect the US$2.5trn of obligations guaranteed by the bond insurers, the agency says.
The ripple effects of the still-unfolding sub-prime lending situation have affected various directly-related markets, as such markets trade in or reference sub-prime loans or other securities that hold such loans. The holders of these instruments, the banks and money market investors, as well as certain hedge funds to date are estimated to have suffered more than US$130bn of losses. Now the bond insurers, which have insured some of these instruments, are also being affected and the issues are becoming relevant to a broader cross-section of the market.
Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities and downgrading them could affect all markets in which they are active, including the municipal bond, CMBS and other structured finance areas. In turn, dislocation in those markets could affect banks.
S&P believes that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades. Large global institutions have direct exposure to the bond insurers in a number of ways.
The area that represents the potential for the highest losses is the hedges that the bond insurers provide for super-senior CDO tranches. To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures.
However, US$125bn of sub-prime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is.
Citi reported that it had bought protection on US$10bn of super-senior tranches of high-grade CDOs (not necessarily all from bond insurers), Merrill Lynch reported US$19.9bn of hedges with bond insurers and CIBC US$9.9bn. The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts.
In some cases, banks have taken reserves against the increased counterparty risk represented by their own assessment of the credit deterioration in bond insurers. Citi added US$900m to reserves, Merrill Lynch added US$3.1bn and CIBC announced US$2bn – with the majority of that related to ACA's severe downgrade to triple-C. More reserving may be necessary to reflect the increase in counterparty risk, if the ratings on guarantors are lowered.
Some of the CDOs hedged by bond insurers are part of a negative basis trade strategy. The spread earned on the CDOs compared to the firm's cost of funds, deducting the cost of the monoline insurance, can be present valued and reported as current income because the position is deemed to be hedged. If the hedge is deemed to be "ineffective", however, that income may need to be reversed.
Meanwhile, the bond insurers cover US$1.5trn of municipal bonds, a much greater amount than CDOs, but the effect is not likely to be as great for banks. Although the bond insurers' downgrades will mean downgrades of the municipal bonds they insure, the stand-alone strength of the municipalities is generally investment grade or high investment grade.
Assuming the ratings remain in the double-A area, the price effect is not likely to be very significant – although the fact that some investors cannot hold securities rated below triple-A may exacerbate price declines if there is widespread forced selling. However, the effect of municipal bond downgrades will not be concentrated, potentially affecting a wide variety of smaller, mainly US banks, as well as the larger ones that commonly hold such securities on their balance sheets.
A somewhat bigger issue than simple holdings of municipal bonds is that some large banks have provided liquidity lines to three different types of SPEs that fund municipal bond investments wrapped by monolines: tender option bonds (TOBs); variable-rate deposit obligations (VRDOs); and auction rate programmes. With the downgrades and price depreciation, investors in TOBs have been exercising their right to tender the municipal bonds back to the banks at par. The banks that hold the subordinated notes in these programmes must not only fund the bonds on their own balance sheets, but must absorb any mark-to-market losses on these bonds.
Downgrades have also been pulling funding away from VRDOs, so banks must, at least temporarily, take these bonds back on balance sheet until the municipalities can restructure their bonds. The auction rate programmes require no obligation on the part of the banks other than to remarket the bonds when the auction fails.
In addition, these banks might provide the SPEs with default protection on the municipal bonds (Merrill Lynch disclosed US$7.9bn of such protection in September). While the mark-to-market losses from downgrades to the double-A level are not likely to be very significant, the bigger issue is liquidity management, as large amounts of securities need to be funded on balance sheet. Although banks can manage the liquidity needs related to municipal bonds, dedicating additional funds to this area may curtail the amount of liquidity available for other needs.
The larger concern is that the bond insurance downgrades may affect not just the key markets in which the bond insurers are directly active, but general markets spread beyond the limited sectors affected to date. This could lead to a further prolonged period of generalised market disruption and a loss of confidence that would not be favourable for any financial institution, S&P says.
At present, it would be difficult to opine on the likely effects on the financial sector of a generalised market disruption. At a minimum, the agency believes that trading results could be affected, as could fixed income business volumes.
Bright future for ILS
JPMorgan's global structured finance research team in New York (JPM) and risk & reinsurance specialist Guy Carpenter (GC) have published reports on insurance-linked securities (ILS). Both are bullish about the products' future.
"We anticipate there is still significant scope for further growth, and expect that securitisation and financial markets can increase underwriting capacity for reinsurers. We project annual issuance of cat bonds to exceed US$10bn in 2008; 2002-2007 growth experience was 47% compounded annual growth," says the JPM report 'Catastrophe bonds and sidecars – a primer'.
The JPM analysts also expect further growth in P&C risk transfer via sidecar transactions. "High insurer capital requirements for peak catastrophe risks will drive cat bond and sidecar growth," they say.
The JPM report goes on to note that cat bonds offer investors a risk whose performance is uncorrelated with other financial instruments. Further, cat bonds also offer an attractive spread pick-up relative to comparably-rated corporate credit and these spreads almost always exceed the modelled expected loss.
Moreover, the GC report – 'ILS comes of age: structured products on the horizon' – says the next stage in the maturation of the market is to structure ILS products using cat bonds, industry loss warranties (ILWs) and derivatives written on both. It says: "Going forward, (re)insurers eager to transfer risk and investors seeking potentially outsized returns are likely to turn to structured products... By customising securities via the CDO structure, decisions can be made on the alpha and beta of a single contract, allowing investors to assess the impact of an inherently diversified portfolio."
GC concludes: "Customised CDOs can be selected for specific characteristics, alleviating the pressure on institutional and individual investors to find individual cat bonds, ILWs or non-ILS that may not meet a portfolio manager's particular needs. The utilisation of structured products is just beginning, but hopes are high."
SIV restructuring continues
Further SIV restructuring activity emerged over the last week. Standard Chartered plans to purchase CP issued by its Whistlejacket vehicle to enable it to meet its senior obligations, provided noteholders agree to drop enforcement conditions that would be triggered by a decrease in NAV below 50%. And HSBC has established two new vehicles – Mazarin Funding and Barion Funding – with which Cullinan income note investors can exchange their holdings.
A proportion of Cullinan's assets will also be transferred to the new vehicles, which will have no market value triggers. Mazarin is structured as an ABCP conduit that is backed by a 100% liquidity facility from HSBC, while Barion is a term funded vehicle. HSBC is reportedly considering restructuring options for its other SIV Asscher.
Meanwhile, Citi has repurchased US$25m second priority senior MTN notes due May 2011 issued by its Sedna Finance vehicle.
European asset performance set to decline
S&P says that the performance of assets backing many European structured finance transactions is set to decline over the next 12 months, constraining new issuance volumes, but expected losses in collateral pools should generally remain lower than the agency's rating stresses. Unprecedented disruption in the global capital markets, caused in large part by problems in the US mortgage sector, means that certain structures and particular asset types may disappear from the European market altogether and others may be under some ratings pressure for the foreseeable future.
On the whole, collateral performance issues over 2008 are most likely to affect speculative-grade or low investment-grade ratings, with most high investment-grade ratings expected to remain generally stable. At a sector level, credit risk is expected to rise in certain CDOs and RMBS.
Looking ahead, the agency will be watching the small number of ABS CDO transactions backed by US RMBS collateral, where structural triggers related to asset ratings could cause early liquidation of the portfolio into a depressed market. While these and other pockets of weakness are emerging, the fundamental credit risk across the European asset-backed markets generally remains good. S&P believes that the divergence between bond spreads and ratings, at least as far as higher grade tranches are concerned, represents an overdue re-pricing of credit risk rather than a significant increase in credit risk itself.
The agency's 2007 European structured finance transition study highlights that rating changes among European structured finance securities were again stable, but that certain credit risks are worsening. "Our study shows that more than 97.5% of ratings remained the same or were raised over the course of the year, an improvement on 96.5% in 2006," comments Simon Collingridge, S&P md and head of European surveillance. "Despite the comparative stability these statistics demonstrate, the default risk of the underlying assets did increase in some sectors. This has generally not been sufficient to cause negative rating actions so far and the default rate in 2007 was only 0.32%. But collateral performance in a number of European structured finance asset classes will likely worsen in 2008."
Collingridge notes that structural features – notably rising credit enhancement over a transaction's life – in many cases more than compensate for deterioration in the underlying asset pool.
The outlook for new issuance in Europe's securitisation markets is proving particularly difficult to read, meanwhile. "Whatever happens, public issuance in the first half of 2008 will be very subdued compared with 2007," says Ian Bell, head of European structured finance at S&P. "Thereafter, the trend will depend on whether the fundamental re-pricing that we are seeing across the whole credit spectrum settles at a point where securitisation transactions once more become attractive for both investors and originators."
He adds that global re-pricing is expected to settle down around the middle of 2008. "If this comes to pass we could see a strong pick-up in issuance in the second half of the year, but should this not occur then it is likely that issuance volumes will lag those of 2007."
At a sector level, European CDOs face a difficult year ahead, but the market is expected to return – albeit with more plain vanilla, tailor-made structures and a continued focus on higher quality assets. "Breaking the sector down further, we see that all products face challenges, but those structures least exposed to US structured finance assets and those without a market value element show greater resilience," Bell continues.
Further Quebecor-related rating actions...
Fitch Ratings has placed 36 tranches from 20 public CDOs and six tranches from five private CDOs on rating watch negative (RWN) following Quebecor World Inc's filing for credit protection under the Companies' Creditors Arrangement Act on 21 January 2008. The agency has identified 23 Asian (all synthetic), 39 European (38 synthetic, one cash) and 11 US (nine synthetic, two cash) transactions, with a total portfolio notional exposure to Quebecor of €3.9bn-equivalent.
The majority of deals that were placed on RWN were European. No Asian deals were placed on watch, while only two US deals – both privately rated – were placed on RWN.
Transactions with exposure to Quebecor which have not been placed on RWN are expected to have sufficient credit enhancement or excess spread to support the current ratings upon Quebecor's default. In performing the analysis, Fitch applied a 50% recovery rate assumption derived from market value estimates, except for deals where fixed recovery rates were applicable.
Fitch will resolve the RWN status on the CDOs when final valuations for Quebecor in each transaction are made available and when Fitch's new CDO criteria is finalised.
...as protocol is launched
ISDA has announced the launch of a protocol created to facilitate settlement of credit derivative trades involving Quebecor World Inc, a Canadian printing company that filed for creditor protection under the Canadian Companies' Creditors Arrangement Act on 21 January 2008 (see SCI issue 72).
The 2008 Quebecor CDS Protocol permits cash settlement of single name, index, tranche and other credit derivative transactions referencing Quebecor. It enables parties to agree to settle their trades on a multilateral basis, based on a final price established at auction. This approach to settlement brings considerable operational efficiencies, while also preserving a participant's right to receive or deliver obligations if desired, ISDA says.
Markit and Creditex will administer the auction, scheduled for 19 February 2008, which will determine the final price for Quebecor bonds.
"At a time when credit concerns are permeating the global financial markets, the ISDA mechanism reassures derivatives industry participants of a smooth and reliable settlement process," comments Robert Pickel, ISDA's ceo and executive director. "ISDA is committed to supporting the integrity of credit risk management practices and operational efficiency across privately negotiated derivatives."
While earlier ad hoc protocols enabled cash settlement only of index trades, the move marks the second time this settlement methodology has been applied to a broad range of credit derivative transactions. The mechanism was successfully implemented in the 2006 Dura CDS Protocol.
The Protocol is open to ISDA members and non-members alike. The adherence period for the Protocol runs until 8 February.
Japanese CRE CDO trends analysed
Moody's has released a report which explores trends in Japanese CRE CDO transactions and the expected collateral of such deals. The report also explains its approach to analysing CRE CDOs and notes some of the issues regarding management and monitoring of the transactions.
The report is based on Moody's previous report detailing its approach to rating EMEA CRE CDOs, making adjustments to information on elements that are specific to Japanese commercial real estate transactions, such as the evaluation method of underlying commercial real estate related assets.
QWIL enters repurchase agreement
Queen's Walk Investment Ltd (QWIL) has entered into an irrevocable, non-discretionary arrangement with Citi and JPMorgan Cazenove to repurchase on its behalf ordinary shares in the company for cancellation during the close period commencing on 4 February and ending on or around 5 March 2008, being the proposed date for the publication of its 31 December 2007 interim results.
The maximum price to be paid shall be not more than 105% of the average of the middle market quotations for the company's shares for the five business days before the day on which purchase is made. JPM Caz and Citi will have the authority to consider, on each trading day, repurchasing more than 50% of the average daily trading volume of the company's shares traded over the 20 trading days preceding that date. The sole purpose of the share buy back is to reduce the capital of the company.
CB MezzCAP downgraded
S&P has removed from credit watch with negative implications and lowered its ratings on the Class B, C, D and E notes issued by CB MezzCAP Limited Partnership, a German SME CLO transaction. At the same time, the triple-A rated Class A notes were placed on watch negative.
The rating actions take into account the latest insolvency in the portfolio, ODS Optical Disk Services GmbH, and its effect on the structure. ODS is one of the SMEs in the underlying portfolio to which the issuer made cash advances. The portfolio analysis relies on updated probabilities of default for each company in the portfolio, which were quantitatively derived by using CreditRiskTracker and running 2006 year-end financials.
"Based on the most recent information made available to us, the portfolio credit quality has significantly decreased. Furthermore, we have to assume that ODS's insolvency will have a severe effect on the level of losses incurred by the issuer under its participation right," says credit analyst Viktor Milev.
ODS had issued a €6m profit participation right to CB MezzCAP and filed for insolvency on 5 October 2007. The default of the company triggered a principal deficiency event in the transaction, and consequently the €6m exposure was credited to the principal deficiency ledger (PDL).
Milev adds: "Whether or not a recovery will be achieved, and what the potential level of that recovery could be, depends on further insolvency proceedings. At the moment, we can only assume a minimal recovery rate due to the deeply subordinated nature of the participation right. We will continue to monitor the insolvency proceedings and remain in close contact with the financial adviser and transaction monitor to obtain the latest available information on the recovery process."
As of the 25 January 2008 payment date, the PDL in the transaction was €15.8m. The actual clearance of the PDL will depend on the availability of future excess spread and on potential recoveries received.
"In our analysis, which included credit and cashflow modelling of the transaction, we assumed a minimal recovery on the last two defaulted entities, Erich Rohde KG and ODS. Our CDO Evaluator was applied to derive updated scenario default rates at the various rating levels. This modelling relied on the updated probabilities of default and took into account the remaining term until maturity of the underlying participation rights," concludes Milev.
EMEA CDO outlook
The EMEA CDO market continued to see sustained growth in issuance levels in 1H07, but the impact of the US sub-prime crisis and general credit turmoil 2H07 resulted in only a modest overall rise in issuance for the year, says Moody's in its "2007 Review & 2008 Outlook" report on this market. Uncertainties over the timing of a market recovery make issuance predictions challenging, but the agency believes a year-on-year decline of between 30% and 50% is not unlikely in 2008.
Total CDO issuance in EMEA rose 11% in 2007 to €112.8bn compared to 2006, though the number of deals increased at a somewhat higher rate of 20% to 304 from 251. "The slowdown in activity in the second half was an unprecedented phenomenon in the history of CDOs in the EMEA region: the lower volumes that we had seen in 2003 and 2004 reflected the development of the single-tranche market, which was associated with smaller transaction sizes, rather than a downturn in activity," says Florence Tadjeddine, Moody's vp - senior credit officer and author of the report.
She adds: "The most significant factor was certainly the impact of the US sub-prime crisis. Those EMEA SF CDOs that were exposed to deteriorated US assets experienced significant downgrade activity by year-end. SF CDOs that have been affected by either a rating downgrade or a rating review for possible downgrade account for 18% of EMEA SF CDOs and 5% of total EMEA CDOs. More generally, the crisis heightened investors' caution towards structured finance products, thereby creating a severe and generalised drop in market value across virtually all structured asset classes."
In the European leveraged loan market, activity set new records in the first half of the year but issuance then essentially ceased for a number of months on the impact of the credit crisis. This was concurrently reflected in a significant increase in the CLO risk premium and a relative slowdown in issuance after two years of vigorous activity, Moody's report says.
CPDOs continued to attract significant interest but represented only a very small proportion of total CDO issuance. As banks and insurance companies – and particularly monolines – have also been hit by the crisis, spread-widening has affected those CPDOs solely exposed to financial institutions; further widening later triggered performance concerns for other CPDOs, although to a much lesser extent.
Moody's report provides the rating agency's views on the macroeconomic and corporate framework that underpins sector outlooks for leveraged loan CLOs and synthetic arbitrage CDOs of corporates. "Although difficulties are undoubtedly starting to loom in the leveraged loan market, refinancing risk is expected to be moderate and the trend in recent years towards weaker covenants is likely to provide companies with greater flexibility to respond to a weaker operating environment. Rating implications should be limited for leveraged loans CLOs thanks to their structural enhancements," Tadjeddine notes.
However, Moody's believes that, as the deterioration in corporate credit quality is likely to continue, the performance of synthetic arbitrage corporate CDO portfolios is expected to weaken. "This weakening should nevertheless continue to be partially offset by the reduction of risk linked to CDO maturity shortening. However, it is important to note that, if we were to see a few more defaults in the vein of Quebecor World Inc occurring, that would certainly start having rating implications for a number of transactions," the analyst cautions.
In terms of new issuance, balance sheet and SME transactions should remain predominant due to a continuous focus on risk management. Moody's expects CLO issuance to be active, although this is conditional on the primary leveraged loan market and the pricing arbitrage efficiency of the structure.
Sachsen Funding defaults, Duke Funding converted
S&P has lowered to single-C and retained on credit watch with negative implications its ratings on the CP issued by Sachsen Funding I. It is also removing from credit watch negative and lowering to single-D its ratings on the mezz Tier 1, mezz Tier 2 notes and the capital notes.
The ratings actions are based on updated current portfolio values and the notification from SachsenLB Europe, which manages the portfolio, that there were not enough proceeds to pay the obligations on the mezzanine and junior notes. The vehicle remains at risk from further market valuation declines and therefore the CP rating remains on watch negative.
Meanwhile, Moody's has withdrawn its rating on the CP issued by Duke Funding High Grade I due to the exercise of a put option that resulted in the notes being converted to Class A-1 LT-b1 notes.
CDO investor survey results
After polling over 200 investors, JPMorgan has revealed the results of its CDO client survey. A summary of the findings include:
• 68% of respondents believe that one or two monolines will be able to wrap transactions
• Over half believe that spread and headline instability are the main obstacles to participation
• Half believe that the CLO market will re-start in 2008, a third in 2009
• 80% plan to maintain or add CLO exposure in the next 12 months
• Most project global 2008 CLO volume to range between US$30bn-US$50bn (US$136bn in 2007)
• 34% see default rates at 4-5% in 2008; 55% see this outcome in 2009.
Credit conditions reach four-year low
Kamakura Corporation says that its monthly index of troubled public companies increased sharply in January, rising by 1.9% to 12.1% of the global public company universe. Current credit conditions are barely better than the 13.4% average for the index in the 18-year period since January 1990.
Current credit conditions are better than only 51.5% of the monthly periods since the index began. The percent of public companies classified as troubled was as low as 8% in September 2007; credit conditions are now at their worst level since December 2003.
Kamakura defines a troubled company as a company whose default probability is in excess of 1%. The index covers more than 20,000 public companies in 29 countries using the fourth-generation version of Kamakura's advanced credit models.
"If one defines a recession as a period when credit conditions are below average, we are teetering on the brink of a recession right now," explains Warren Sherman, Kamakura president and coo. "The credit crisis that began in late spring is now pervasive. The auto companies, for example, which were in crisis in May 2005, now have default probabilities as high as they had in that crisis period."
Tough month for CLOs
The market took a deep breath as January ended – a month the like of which the CLO sector has not seen before. In Europe, despite three traditional CLOs doing the rounds (Fortress I, Queen St III and Halcyon 08-01), no transactions priced versus a monthly average in 2006/2007 of €2.6bn or six deals, according to structured credit strategists at RBS. One US CLO priced: Silvermine Capital's ECP CLO I is a low-levered deal (6x), with AAA/AA/A spreads at 85/300/400bp (versus December's average spreads of 75/300/375bp).
A new €320m European transaction – dubbed Base CLO – has begun marketing and the strategists estimate that a further €2.5bn of CLOs is in the wings for H1, albeit they are still warehouse-clearing exercises. Whereas the traditional CLO was pretty much the only way to buy leveraged loan portfolios over the past few years, going forward they expect more variety in leveraged loan portfolio structures – such as TRS, low levered, funds and synthetic – as banks continue to explore ways to clear out the leveraged loan overhang.
Whether February will fare any better for the CLO sector depends on the fortunes of the triple-A benchmark prime RMBS and the monoline issue. The catalyst to reopen the primary CLO market lies, the strategists believe, in establishing a clearing level in prime mortgages. This would help restore the disturbed natural pricing order of the securitisation markets (balance sheet CLO tranches have recently traded wide to their arbitrage CLO homologues).
With around 60% of triple-A CLO paper being monoline wrapped, the outcome in this sector is very relevant to triple-A CLO spreads dynamics – with risk that, as downgrades occur, selling activity will occur. Additionally, over the long term triple-A funding costs are likely to remain elevated.
S&P reports on rating transitions
As 2007 came to a close, the global CDO market reflected on a year marked by increased rating volatility, widening credit spreads, a liquidity squeeze, severe markdowns and a sharp drop in issuance (particularly during the fourth quarter). S&P downgraded approximately US$103.3bn (5.59%) out of the US$1.85trn in original issuance for outstanding global CDOs during the year.
The overall credit quality of global CDOs, when accounting for both the frequency and magnitude of rating transitions for the entire year, declined approximately 25% of a notch in 2007, compared with an increase of about 1% of a notch in 2006. On the market value side, SIVs and SIV-lites also experienced an unprecedented level of rating volatility during the second half of 2007.
'Transition' refers to how much an S&P rating has changed, either up or down, over a certain timeframe. These transition rates can be useful to investors and credit professionals in various ways because they show the degree to which the agency's ratings are stable or volatile.
The unusual number of downgrades that S&P took on RMBS collateralised by US mortgage loans contributed significantly to the rating volatility of synthetic, cashflow and hybrid ABS CDOs. Overall, the agency downgraded approximately US$107.7bn (2.55%) out of about US$4.2trn in original issuance for outstanding US RMBS in 2007. This rating volatility in RMBS and CDOs collateralised by these securities also led to downgrades in CDO-squared transactions.
Among the cashflow corporate segments, however, credit performance for CBOs and CLOs improved in 2007. ABS CDO issuance declined sharply late in the year because these transactions saw high rating volatility. This was primarily due to the poor performance of the 2005, 2006 and 2007 vintage RMBS securities, which make up a significant proportion of the collateral for many 2006 and 2007 vintage ABS CDOs.
For the third consecutive year, synthetic corporate investment-grade CDOs with exposure to issuers downgraded to speculative grade from investment grade dominated the downgrades.
In 2007 overall, conditions for corporate credit remained relatively benign and the US high-yield annual corporate default rate was at a 25-year low of 0.97%. However, S&P downgraded some frequently referenced investment-grade corporate obligors to speculative-grade levels during the year.
A number of these rating actions were related to private equity firms' leveraged buyouts of companies, such as Alliance Boots, ALLTEL Corp, TXU Corp and First Data Corp. These events affected the credit quality of CDOs, particularly synthetic transactions.
S&P expects the US high-yield corporate default rate to increase through 2008 and head even higher if the US suffers a recession. Any further rise in defaults could potentially hurt the credit quality of CDOs, especially those backed by corporate securities.
As the market enters 2008, CDO ratings will depend on the state of the global economy and the risk of recession; labour markets; interest rates; and, most important, housing market fundamentals, as well as the performance of corporates and RMBS. S&P expects the downgrades and defaults of CDOs backed by RMBS will continue through 2008 as a result of the large number of RMBS downgrades since July 2007. In addition, the agency expects that the US housing market-related concerns and the possibility of a recession may continue to create rating volatility for ABS CDOs collateralised by RMBS tranches through 2008.
It's important to note that so far rating volatility has primarily affected mortgage-related securities and borrowing and, to a lesser extent, financial institution ratings. If the current credit problem spreads into the corporate world in 2008, however, downgrades and rating volatility for CDOs backed by corporate credits could result.