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A round up of this week's structured credit news
SCA downgraded
Moody's has downgraded to A3 the insurance financial strength ratings of the operating subsidiaries of Security Capital Assurance, including XL Capital Assurance and XL Financial Assurance. The agency has also downgraded the debt ratings of the holding company, Security Capital Assurance Ltd, and a related financing trust.
These rating actions reflect Moody's assessment of SCA's weakened capitalisation and business profile resulting, in part, from its exposures to the US residential mortgage market. The rating outlook is negative.
As a result of this downgrade, the Moody's-rated securities that are guaranteed or by XLCA and XLFA are also downgraded to A3, except those securities with higher public underlying ratings.
Based on the risks in SCA's portfolio, as assessed by Moody's, capitalisation required to cover losses at the triple-A target level would exceed US$6bn. This compares to Moody's estimate of SCA's claims paying resources of US$3.6bn, which the agency considers to be more consistent with capitalisation at the single-A rating level. It further notes that it estimates SCA's insured portfolio will incur lifetime expected losses of approximately US$1.2bn in present value terms.
SCA is currently pursuing several capital management initiatives that, according to Moody's, if successfully executed could reduce but would not likely eliminate the company's capital shortfall at the triple-A rating level. Moody's further comments that capitalisation, and the prospect for improvements in capitalisation, were considered in the context of the rating agency's opinion about the guarantor's ongoing business and financial profile.
In Moody's opinion, SCA's significant exposure to mortgage-related risk has had consequences for its business and financial profile beyond the associated impact on capitalisation, and affects its opinion about SCA's other key rating factors. The agency believes that SCA is more weakly positioned than many of its peers with respect to business franchise, prospective profitability and financial flexibility.
With respect to underwriting and risk management, Moody's believes that SCA's relatively significant exposure to the mortgage sector is indicative of a risk posture somewhat greater than the peer group overall. The company's participation in super-senior mezzanine tranches of ABS CDOs, in particular, contributed to this view. Going forward, Moody's believes SCA's strategic direction could change meaningfully, with implications for the business profile that are currently uncertain.
MBIA raises US$1bn equity
MBIA last week raised US$1bn in equity, an increase from the US$750m originally planned. The shares were sold at a 14% discount, according to structured finance analysts at RBS, with Warburg Pincus taking US$300m of the capital raising.
"MBIA has certainly differentiated itself from its peers in its ability and willingness to raise fresh capital to protect its triple-A ratings. In our view, this may not be enough to maintain its triple-A ratings, but it is certainly a step in the right direction," the analysts say.
Most of the proceeds are likely to be contributed to the insurance company. At the same time, MBIA revised its unallocated loss reserve by US$100m after receiving December 2007 servicer reports for some transactions after the results were originally released. The addition relates to its second-lien RMBS transactions.
Meanwhile, another rumour circulated about the potential monoline bail-out, suggesting that banks may be willing to accept an unwind of the credit protection they have purchased in return for equity warrants.
S&P launches 27-step ratings plan
S&P is implementing new measures to strengthen the integrity of its ratings process (see separate news story for more). Below are brief descriptions of some of the major new actions that the agency is undertaking.
In order to enhance governance, S&P will:
• Establish an Office of the Ombudsman that will address concerns related to potential conflicts of interest and to analytical and governance processes across S&P's businesses that issuers, investors, employees and other market participants may raise. The Ombudsman will oversee the handling of all issues, with authority to escalate any unresolved matters, as necessary, to the ceo of the McGraw-Hill Companies and the Audit Committee of the Board of Directors.
• Engage an external firm to periodically conduct an independent review of S&P's compliance and governance processes. This firm will issue a public opinion that addresses whether the agency is effectively managing potential conflicts of interest and maintaining the independence of its ratings.
• Institute periodic rotations for lead analysts.
• Implement "look back" reviews whenever an analyst leaves to work for an issuer to ensure the integrity of prior ratings.
In order to strengthen analytics, S&P will:
• Complement traditional credit ratings analysis by highlighting non-default risk factors, such as liquidity, volatility, correlation and recovery, that can influence the valuation and performance of rated securities and portfolios of these securities.
• Add new surveillance capabilities, including tools, models and data sets, which will enable S&P to better monitor the performance of collateral pools over time.
• Establish a model oversight committee within the quantitative analytics group, which will be separate from and independent of the business unit, to assess and validate the quality of models and tools.
• Increase annual analyst training requirements, enhance training programmes and establish an analyst certification programme.
In order to increase transparency of information, S&P will:
• Develop an identifier that will highlight to the market that the rating is on a securitisation or on a new type of instrument.
• Include "what if" scenario analysis in rating reports to explain key rating assumptions and the potential impact on the rating of unexpected events. The goal is to help investors better assess an issue's risk profile.
• Work with issuers and investors to improve disclosure of information on collateral supporting structured securities.
• Request greater minimum portfolio disclosure criteria of issuers of certain structured securities.
• Collect more information about the procedures issuers and originators use to assess the accuracy and integrity of their data and to detect fraud.
In order to educate the public, S&P will:
• Create a credit ratings user manual and investor guidelines to promote better understanding of its ratings process and the role of ratings in the financial markets.
• Establish an advisory council with membership that includes risk managers, academics and former government officials to provide guidance on addressing complex issues and to establish topics for market education.
• Broaden distribution of analysis and opinions via the web and other media.
ERMBX no-show halts short plans
News that the proposed launch of Markit ERMBX will likely be delayed beyond March has disappointed those hoping to put on new index-based short strategies. Markit confirmed that, following extensive feedback from all market participants and in light of current volatile market conditions, it has been agreed that any decision regarding the launch of the new index will be made at a later date.
"We had expected Markit's triple-A and triple-B UK RMBS index to push spreads wider, allowing those seeking to short the market with an outlet for their view. However, many market professionals realised this and have taken measures to stop its launch, given the current market predicament. The general consensus is that an index would allow spreads to be pushed much wider than those able to invest at present would be comfortable with," explain structured finance analysts at SG.
For most investors, price stability and transparency are the biggest factors impacting confidence. Clarifying an exact market price is very hard at present, the analysts add, with typical spreads for UK prime triple-A RMBS in the 80-100bp range. While the index would promote price transparency, it would do so at a wide level where few cash sellers would participate.
If launched, the index will offer exposure at the triple-A and triple-B points of the capital structure, based on the seven UK RMBS master trust issuers excluding Granite. There would be one eligible bond per issuer, denominated in euros with an average life of 3-6 years. The bonds must be publicly-placed tranches, with the triple-B tranche being the corresponding subordinated tranche of that included in the triple-A index.
Ben Logan, md of structured finance at Markit, says: "It is Markit's desire to create an index that will attract market support and be actively traded. We will continue to work towards completing the documentation for the index, and will update the market on any decisions that are taken about the launch in due course."
NEO liquidated
S&P has lowered its ratings on all eight tranches from NEO CDO 2007-1 after receiving notification from the trustee of the controlling noteholders' intent to liquidate the collateral and terminate the transaction. The ratings on five of the downgraded classes remain on credit watch with negative implications.
The agency received a notice on 4 February for NEO CDO 2007-1 stating that a majority of the controlling noteholders is directing the trustee to proceed with the liquidation of the collateral supporting the notes. This notice follows a previous notice declaring an event of default as of 18 December, under section 5.1(i) of the indenture dated 5 April 2007.
The rating action reflects S&P's opinion regarding the impact on the transaction of a potential liquidation of the collateral at the current depressed market prices. The controlling class' election to liquidate the collateral at this time may result in losses for all classes of notes. Therefore, the rating actions are more severe than would be justified based solely on the credit deterioration of the underlying collateral.
NEO CDO 2007-1 is managed by Harding Advisory.
Lessons learned from Cheyne Finance ruling
A recent Clifford Chance client briefing highlights the judgment on 17 October given in respect of the meaning and interpretation of "unable to pay its debts as they fall due" in section 123(1)(e) of the Insolvency Act 1986 (IA 1986) concerning Cheyne Finance. This decision is significant because it is the first time a court has directly considered the extent to which future indebtedness not yet due should be taken into account when considering the cashflow or commercial test for insolvency, the law firm says.
"From a credit crunch perspective, where this test may feature in an increasing number of solvency analyses, it is useful to have some guidance and an appreciation of the range of consequences and the different interpretations this test could have. In addition, it is interesting to consider the particular impact it had on Cheyne Finance Plc as a structured investment vehicle (SIV) and its various senior creditors," the authors of the briefing write.
The briefing notes that the court has taken a very commercial approach to this fundamental concept of English insolvency law, in particular considering the reality, in this case, that it was necessary to have regard to future liabilities. They favoured this approach over a literal interpretation of the section which does not in terms refer to prospective or future debts partly because it was a more "flexible" and "fact sensitive" interpretation of the phrase "as they fall due", and did not produce what they considered to be a wholly artificial result of conferring payment priority on the senior creditors who just happened to have shorter priority than other senior creditors of the same class.
For many financings, both the cashflow test in section 123(1) IA 1986 and the balance sheet test in section 123(2) IA 1986 will normally be included as an insolvency or enforcement trigger. This avoids the need to consider in detail some of the issues that arose in the Cheyne case.
For the purposes of wrongful trading, the decision should not affect the directors' analysis of a company's financial position. Directors should continue to take into account both the company's cash flow (which necessitates looking at future debts falling due within the relevant period) and its balance sheet when considering whether it is appropriate to continue trading without the risk of incurring personal liability.
In this case, Cheyne could pay its early maturing senior debt on a 'pay as you go basis', but this would have meant a forced sale of the asset portfolio – which inevitably would have been at a huge discount and, as such, the receivers could not manage or realise the portfolio so as to enable all the senior debt to be paid in full. It was essential, from a practical perspective, and to enable the receivers to fulfil their obligations, to retain flexibility in the disposal strategy so as to try and realise the asset portfolio for the benefit of all those holding the senior debt, to establish an Insolvency Event had occurred within the meaning of the Security Trust Deed. As a result of including future debts in the cashflow test (the balance sheet test having been omitted from the contract), they could achieve this and so implement a more orderly realisation for the benefit of all senior creditors.
Whistlejacket downgraded on NAV breach
Moody's and S&P have downgraded Whistlejacket Capital's MTN and CP ratings, following an enforcement event. Approximately US$6.4bn of securities have been affected.
On 30 November 2007 Moody's placed the ratings of the above programmes on review for possible downgrade. Standard Chartered, Whistlejacket's manager and sponsor, announced on 31 January 2008 that it would provide liquidity support to the vehicle for the repayment of its senior debt.
After that announcement, Moody's received proposals from Standard Chartered addressing the implementation of the necessary facility. The agency had expected the facility to be in place by the end of March 2008.
Due to the deterioration in market value of Whistlejacket's asset portfolio, the vehicle breached its capital value trigger on 11 February 2008, causing an enforcement event. The capital value declined from 55% to 41% between 6 February and 11 February, corresponding to a decline from 95.13% to 93.96% in the average portfolio market value.
Following the occurrence of the enforcement event, control of the vehicle has moved to the security trustee, the Bank of New York Trust Company, which is believed to have appointed Deloitte & Touche as receiver. Deloitte's mandate is to advise the trustee on the course of action that is in the best interest of secured parties.
The trustee has a number of options, including acceleration of senior debt, continuation of the repayment of senior debt as it falls due and completion of the plan initiated by Standard Chartered to provide liquidity support. The long-term rating assigned to the MTN programmes reflects the uncertainty surrounding the course of action that it will pursue. Moody's review will therefore focus on both the intentions of the trustee and the evolution of the market value of Whistlejacket's asset portfolio.
Structured finance analysts at Barclays Capital suggest that the remaining Whistlejacket investors were not quick enough in accepting the sponsor's proposal. "In our opinion, this turn of events highlights the execution risk with complex SIV restructurings and might call into question recent announcements from other bank sponsors, including Citigroup and HSBC regarding the support of their SIV's. More detailed disclosure from each of the SIV sponsors regarding the exact nature of their SIV support should address these concerns," they note.
Permacaps release interim reports
Carador and Queens Walk Investment (QWIL) have released interim management statements relating to the period from 1 October to 31 December2007.
According to Carador's performance summary, the company's share price has increased by 4.5% during the period, but NAV per share has decreased by 7.6%. The NAV includes an estimated €2.2m of net cashflow interest received in the three months ended 31 December 2007 (to be allocated between capital and income), which equates to €0.044 per share.
Carador's fall in NAV was mainly due to the general mark-down in CLO valuations, following the sentiment of the market, the company says. In December, the fall in NAV of 1.9% was mainly due to the mark down of a CLO transaction (where the manager has improved portfolio quality but as a result reduced target returns) and the write-off of a seasoned (largely 2004/05) sub-prime ABS CDO.
In January, the company identified two underlying corporate defaults in one CLO held by Carador, EV8. These represent, in aggregate, less than 0.5% of the CLO portfolio. One of these senior loans traded after the event at a price of 75% versus 12% for the unsecured debt.
Meanwhile, the credit crisis has not had a material impact on the cashflow performance of the QWIL's assets as at 31 December 2007. Cashflows from the company's investment portfolio exceeded €20m per quarter for the three quarters ending 31 December 2007.
As at 30 September 2007, the company's NAV was €6.90 per share, down from a NAV of €7.24 per share as at 31 March 2007. This reduction in NAV has predominantly been a result of write-downs to the company's US-related investments. As at 30 September 2007, the direct and indirect exposure to the US sub-prime mortgage sector was 2.3% of the company's gross asset value.
On 16 July 2007, QWIL replaced its short-term financing with a four-year €135m term financing facility (see SCI issue 54). The financing facility has provided the company with a stable financing solution as it eliminates the liquidity risk of short-term borrowings. The net leverage ratio as at 30 September 2007 was 8.6% (after taking into account cash balances allocated to settle the tender offer and the company's dividend).
Since 18 July 2007, QWIL has returned in excess of €40m of capital to shareholders using a combination of share buyback and tender offers. In October, the company purchased €28m notional of two-year put options struck against 90% of the September 2007 value of the Halifax UK house price index.
The hedge is currently in-the-money as UK house prices have fallen in the last four months. This hedge is intended to minimise portfolio losses in the event that house prices give up the gains that have occurred since early 2006.
LSS deals hit
S&P has lowered its ratings on three leveraged super senior (LSS) CLNs issued by ELM, Midgard CDO and Sceptre Capital. The rating action follows a significant increase in spreads for the underlying assets over the past five to six weeks.
During this period, spread volatility has seen a difference as large as 74bp between the highest and lowest weighted-average portfolio spreads. This trend of increased portfolio spreads has led to the probability of default calculated for each transaction to increase so that it is no longer commensurate with the initial ratings assigned to these transactions.
LSS transactions contain both credit and market value risks associated with the underlying portfolio. The affected transactions have a market value trigger based on the weighted-average portfolio spread and portfolio losses at a given point in time. If breached, this would lead to an unwind event.
CRE CDO delinquencies up
US commercial real estate loan (CREL) CDO delinquencies are up slightly from last month, according to the latest US CREL CDO loan delinquency index from Fitch Ratings. Four new loans contributed to a delinquency rate for January 2008 of 0.70%, compared to last month's delinquency rate of 0.64%.
The loan delinquency index includes loans that are 60 days or greater delinquent, performing matured balloons and repurchased loans. Although the overall delinquency rate for CREL CDOs remains low, it is more than double the rate of the US CMBS loan delinquency rate of 0.28% for December 2007.
The CREL CDO delinquency rate is anticipated to be more volatile than the CMBS delinquency index, given the smaller universe of loans; while the Fitch CREL CDO delinquency index tracks approximately 1,100 loans, its CMBS delinquency index covers over 48,000 loans.
The January 2008 index encompasses ten loans, which includes four loans that are 60 days or more delinquent, four performing matured balloons and two repurchased loans.
Three of the new additions are performing matured balloons. An increase in these types of delinquencies is not surprising, given the difficulty associated with refinancing in today's market. These performing matured balloons include one loan, which was subsequently paid off in full, while the other two such loans are reported to be negotiating loan extensions.
Additionally, asset managers reported that two assets (0.19%) were repurchased from two separate CDOs in January 2008. One of the loans was included in the December 2007 index as a performing matured balloon, while the other loan was reportedly less than 30 days delinquent in December, and thus not included in the index. Given the lower available liquidity in the market, Fitch expects fewer repurchases of troubled loans and more workouts within the trust.
The agency also reviewed loans that were 30 days or less delinquent. Although not included in the loan delinquency index, this category can be an early warning signal that a loan could ultimately be classified as delinquent.
Two loans, representing 0.07% of the CREL CDO collateral, were 30 days or less delinquent in January 2008. This statistic is down from last month's total of 0.15%, which included a chronic late payer that is now current.
In its ongoing surveillance process, Fitch will increase the probability of default to 100% for delinquent loans that are unlikely to return to current. This adjustment could increase the loan's expected loss in the cases where the probability of default was not already 100%.
The weighted average expected loss on all loans (pool-wide expected loss, PEL) is the credit metric used to monitor the performance of a CREL CDO. Issuers covenant not to exceed a certain PEL and Fitch determines the ratings of the CDO liabilities based on this covenant.
Fitch analysts monitor the as-is PEL over the life of the CDO. The difference between the PEL covenant and the as-is PEL represents the transaction's cushion for reinvestment and negative credit migration.
Lifeline for sub-prime?
Bank of America, Citi, Countrywide Financial, JPMorgan, Washington Mutual and Wells Fargo have announced their participation in Project Lifeline, a new plan to help troubled mortgage borrowers of all stripes, not just sub-prime. The banks pledged to try to contact borrowers that are at least 90 days past due and, in some cases, offer a 30-day freeze on foreclosure proceedings while loan modifications are considered. The plan will not apply to loans that are in bankruptcy, have a foreclosure sale date within 30 days, or are investor or vacant properties.
There is no mention of forbearance plans in the proposal, nor does it guarantee a loan modification. The programme is not a foreclosure moratorium, but a case-by-case foreclosure pause where appropriate, note analysts at Barclays Capital.
The analysts say they have reservations as to whether 30 days is long enough to determine if loan modifications will help borrowers currently 90+ days delinquent. Ultimately, most borrowers in this cohort likely cannot afford their loans at the current terms, so a proposal to pause foreclosures and potentially offer loan modifications is likely to have only incremental effect.
To the degree that foreclosure pauses do not result in modifications, the net effect may simply be a slight worsening of loss severities. The analysts estimate a loss severity increase of roughly 1% if all sub-prime loans were paused, but since only a small fraction of loans is likely to be paused, the overall effect on losses should be negligible.
Solid CDO issuance for Japan
The Japanese CDO market in 2007 saw comparably solid issuance of balance-sheet CDOs and SME CDOs while the market was affected by US sub-prime turmoil, says Moody's in its review and outlook for the sector.
In 2007, Moody's Tokyo office rated 43 deals totalling approximately ¥1.1trn. These included 14 balance-sheet CDOs, including SME CDOs, totalling ¥680m, and 27 deals totalling ¥420m of arbitrage CDOs and other related deals.
Japanese CDO market transaction amounts in 2007 were not robust as a whole, mainly because Japanese investors became cautious, especially in the second half of the year, due to US sub-prime turmoil. However, the actual number of balance-sheet CDOs and SME CDO transactions rose, while the number of arbitrage synthetic CDOs and repackaged deals declined.
Stable European SME CLO performance
Fitch says that the performance of European SME CLOs in 2007 was largely stable, with a few downgrades across transaction type. This information is available in the agency's latest issue of its Pan-European SME CDO performance tracker (SME Tracker) report.
This issue of the quarterly report presents issuance volume and rating actions for the year ended 31 December 2007, while the performance trends across jurisdictions and transaction type are as of the end of September 2007 for comparison purposes.
The report concludes that Spanish SME CLOs have generally performed in line with expectations through Q407. Of the 200 tranches reviewed, only one tranche has been downgraded and another assigned a distressed rating. Nevertheless, rising delinquencies and anticipated slowdown in the real estate sector remain sources of concern.
The report also highlights that German capital market mezzanine CLOs have suffered several downgrades in the Preps transactions. This was due to a clustering of actual defaults, as well as increased risk of future defaults. Further, balance-sheet SME CLOs continued to exhibit largely stable performance, with 86 tranches affirmed from 16 transactions.
Moody's reports on Spanish SMEs
In Q107 Spain was the second-largest European SME market after Germany, but by the end of 2007 the Spanish market had become the largest issuer of true sale SME transactions in Europe, notes Moody's in it new Spanish SME Q407 Index report .
"Some €30.2bn worth of SME notes were issued in Spain in 2007, up from €17.6bn in 2006, with two-thirds of last year's transactions securitised in Q4 2007," says Ludovic Thebault, a Moody's senior associate and co-author of the report.
Delinquency performance – measured as more than 90 days overdue up to the point of artificial write-off – was stable in Q407. Older vintages perform better than newer vintages, as delinquencies for the 2005 vintage trended as high as 0.95% whereas the 2003 vintage showed levels of 0.30% to 0.40% 24 months after issuance. So far, cumulative defaults have remained low in Spanish SME transactions, with often only a few basis points of defaults two years after closing.
Three transactions drew down on their reserve funds last year: IM Grupo Banco Popular Empresas 1, FTPYME Bancaja 4 and PYME Bancaja 5. In IM Grupo Banco Popular Empresas 1, the reserve fund was not fully funded at closing and was meant to increase overtime towards its target level of €45m.
In Q3, however, a large unpaid loan led to a decrease of the reserve fund. The situation returned to normal in Q4, and the reserve fund is now coming close to its target level.
While draws by FTPYME Bancaja 4 and PYME Bancaja 5 were primarily performance-related (high delinquencies in the case of FTPYME Bancaja 4 and one large default in the case of PYME Bancaja 5), an imperfect interest rate swap also limited the amount of excess spread available, according to the Moody's report.
"Spain has enjoyed a sustained period of robust economic growth, contributing to the good performance of SME transactions," says Nitesh Shah, a Moody's economist and report co-author. "However, a sharp real-estate recession could seriously affect the SMEs involved in the sector, as well as the collateral involved (mortgage values)."
Although the percentage of mortgage collateral included in the securitised portfolios has reduced over time (in 2003: 76%; 2007: 47%), Moody's highlights in the current report the linkage of the Spanish SME securitisation to the Spanish real estate market.
More S&P downgrades
S&P has lowered its ratings on 94 tranches from 17 US cashflow and hybrid CDO transactions worth a total issuance amount of US$8.9bn. The downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on sub-prime RMBS securities, as well as the changes S&P has made to the recovery rate and correlation assumptions it uses to assess US RMBS held within CDO collateral pools.
All of the affected transactions are mezzanine ABS CDOs collateralised in large part by mezzanine tranches of RMBS and other SF securities. The transactions are among the CDOs most affected by the agency's recent RMBS rating actions. Thus, the results for these deals may not necessarily be indicative of the outcomes S&P expects for all of the remaining mezzanine ABS CDOs with ratings currently on watch negative.
To date, the agency has lowered its ratings on 1,449 tranches from 426 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 2,573 ratings from 628 transactions are currently on watch negative for the same reasons. In all, the affected CDO tranches represent an issuance amount of US$342.2bn.
Duke Funding assigned DR rating
Fitch Ratings has assigned distressed recovery (DR) 6 ratings to Duke Funding High Grade II-S/EGAM I Series 1 and 2 notes. The action is due to notices being provided by the issuer that events of default have occurred.
Although there is a forbearance agreement in place with the repo counterparties, Fitch does not expect any recovery on the notes. The issuer is a market value structure that closed in March 2006 and is managed by Ellington Global Asset Management.
The proceeds of the notes were used to acquire a diversified portfolio of triple-A rated, primarily floating-rate private-label prime, mid-prime and sub-prime RMBS. The portfolio is levered using reverse repurchase agreements.
Asia Pacific SROC results
S&P has placed its ratings on six Asia-Pacific synthetic CDOs on credit watch with positive implications. Additionally, the ratings on seven other CDOs have been placed on credit watch with negative implications.
The synthetic rated overcollateralisation (SROC) levels for the ratings placed on watch positive rose above 100% at a higher rating level during the end-of-month SROC analysis for January 2008, indicating positive rating migration within the reference portfolio. For those transactions that have been placed on watch with negative implications, the SROC decreased below 100% at the current rating level.