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A round up of this week's structured credit news
Tricadia preps CDPC
Moody's has assigned a provisional counterparty rating of Aaa to Harbor Road Financial Products, Tricadia CDPC Management's new CDPC. The vehicle will invest in a diversified portfolio of high attachment point tranches referencing corporate or sovereign credits through the CDS market.
Moody's provisional rating relies on Harbor Road being managed with a capital model that restricts its ability to trade. The capital model examines the impacts of potential counterparty defaults and changes in market rates on the calculation of required resources. In addition to the required resources suggested by the capital model, a buffer will be added to reflect non-quantifiable sources of risk, such as operational failures.
In reaching its ratings, Moody's took into consideration the expertise of Harbor Road's manager, a subsidiary of Tricadia Holdings. Tricadia and its affiliates have approximately 40 professionals focused on the administration, analysis and trading of credit-related products. The Tricadia team currently manages approximately US$8.3bn in hedge funds, managed accounts, CDOs and permanent capital businesses.
Moody's ability to monitor Harbor Road will be enhanced by agreed upon procedures conducted by an independent auditor, which will report on a regular basis on the CDPC's compliance with certain provisions of the operating guidelines, including the processing of transactions, the maintenance of required resources and the various capital and cashflow calculations.
Fitch downgrades MBIA
Fitch has downgraded the insurer financial strength (IFS) ratings on MBIA Insurance Corp. (MBIA) and its subsidiaries to double-A from triple-A, and the long-term rating of its parent company MBIA Inc. to single-A from double-A. At the same time, MBIA has been removed from rating watch negative – although the rating outlook is negative.
This action is based on Fitch's current views on capital adequacy, the company's updated business plan, consideration of various qualitative ratings factors, an update on Fitch's current views of the portfolio quality of MBIA's insured portfolio, and an analysis of MBIA Inc.'s investment management service (IMS) operations and holding company activities.
As a key basis for the rating action, Fitch believes that MBIA's pro-forma claims paying resources at year-end 2007 of US$16bn now fall below Fitch's triple-A capital targets by a range of US$3.4bn to US$3.8bn, but are consistent with Fitch's updated standards for double-A capital. These figures fully consider the US$2.6bn of capital already raised by MBIA earlier this year.
Fitch notes that MBIA's updated business plans include several improvements to its risk management framework for its operating financial guaranty companies. For example, the permanent exit of several riskier capital intensive structured finance businesses, including CDS execution, and a re-dedicated commitment to focus on its lower-risk core municipal franchise.
In addition, MBIA's suspension of underwriting all structured finance exposures for a six-month period will result in the build up of capital (assuming relative stability of underlying ratings in the existing insured portfolio), as the company will benefit from the amortisation of existing insured obligations – some of which exhaust a material amount of targeted capital resources. This will possibly aid MBIA's return to triple-A capital standards in the future and, more importantly, limit the risk of volatility in the insured portfolio over the intermediate term.
Looking ahead, Fitch believes it will be difficult for MBIA to stabilise its credit trend until the company can more effectively limit the downside risk from its structured finance CDOs through reinsurance or other risk mitigation initiatives. This is a key consideration in the negative rating outlook that presently applies to MBIA's ratings.
Furthermore, assuming sub-prime risk can be stabilised, Fitch does not believe it will be possible for MBIA to significantly improve its credit profile until the company can more fully re-establish momentum in the financial guaranty market, especially in the core US municipal finance sector. To date, on a relative basis, Fitch notes that MBIA's franchise has been less impacted than those of several other sub-prime exposed financial guarantors.
The agency also believes that MBIA's credit profile will be influenced by clarification on its future corporate structure, which may include separation of its operations into segregated municipal finance and structured finance businesses. The credit profile will also be sensitive to management's ability to demonstrate that it can successfully execute its strategic business plans, and that its board of directors can provide effective oversight in a very challenging operating environment. Going forward, these qualitative business, management and franchise-related factors will take on added consideration in future ratings reviews of downgraded financial guarantors.
OCC reports on bank losses
Insured US commercial banks lost US$9.97bn trading cash and derivative instruments in the fourth quarter of 2007, down US$12.3bn from third-quarter revenues of US$2.3bn. For the full year, banks recorded US$5.5bn in trading revenues, down US$13.3bn from the record of US$18.8bn in 2006, the Office of the Comptroller of the Currency has revealed in its Quarterly Report on Bank Trading and Derivatives Activities.
"The large losses in the fourth quarter are the result of well-publicised write-downs on the super-senior tranches of collateralised debt obligations backed by sub-prime residential mortgage securities," says deputy comptroller for credit and market risk Kathryn Dick. "We expected to see an adverse effect on trading results, given current turbulent conditions in the credit and capital markets, particularly in light of the deterioration in market liquidity."
Commercial banks reported credit trading losses of US$11.8bn in the fourth quarter, compared to losses of US$2.7bn in the third quarter. Revenues from interest rate contracts decreased US$3.3bn to a loss of US$357m. Revenues from foreign exchange transactions decreased 7% to US$1.9bn.
The report shows that the notional amount of derivatives held by insured US commercial banks decreased by US$8trn in the fourth quarter to US$164tr. The fourth quarter derivatives total is 25% higher than a year ago. Credit derivatives increased 3% during the quarter to a notional level of US$14.4trn, 60% higher than a year ago.
The OCC also reports that the net current credit exposure – the primary metric it uses to measure credit risk in derivatives activities – increased by US$57bn, or 22%, during the quarter to US$309bn. The measure is 67% higher than at the end of 2006.
"The decline in interest rates and widening credit spreads have caused sharp increases in derivatives fair values, and netting benefits have not kept pace the past two quarters," comments Dick. The percentage of gross fair values offset by netting, which reached a peak of 86.4% in the second quarter of 2007, has declined to 83.8% in the fourth quarter.
The report also notes that derivatives contracts are concentrated in a small number of institutions: the largest five banks hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%. Credit default swaps are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.
The number of commercial banks holding derivatives increased by 18 in the quarter to 955.
Sigma downgraded
Moody's has downgraded Sigma Finance's Euro and US MTNs from Aaa and Prime-1 to A2 and Prime-2, and its CP programme from Prime-1 to Prime-2. The ratings have been left on review for downgrade.
Continuing uncertainties surrounding the SIV's ability to absorb the heightened and unprecedented levels of stress in the credit markets, coupled with further deterioration in its asset prices caused the rating actions. Although unusual, the combination of an A2 long-term rating and a P-2 short-term rating reflects the high credit quality of the company's assets and the liquidity challenges it faces.
Sigma's pre-crisis business model relied on the issuance of commercial paper and medium-term notes. Subordinated debt in the form of capital notes was also issued, with the proceeds used to fund a portfolio of diversified and highly rated assets.
Severe disruption in the new debt issuance market for commercial paper, medium term and capital notes caused Sigma to rely instead on repurchase agreements, ratio trades and outright asset sales in order to repay its maturing debt. Gordian Knot has been successful in establishing new repo lines, taking the number of counterparties to 17 and the outstanding amount of repos to US$14bn as of 2 April. Both figures increased sharply from their low pre-crisis levels.
A further positive feature of Sigma's repos is the length of the commitments, currently averaging seven months. Ratio trades involve the sale of assets at par to Sigma's senior debt investors in exchange for cash and the extinguishing of Sigma's debt held by the investor. A total of approximately US$4bn of assets have been sold in ratio trades, with the majority of assets (US$3.9bn) being structured finance securities (including auto loans, credit cards, CDOs and RMBS), and the remainder financial institutions debt.
While ratio trades and repurchase agreements provide much needed liquidity to the company, investors and repo counterparties could themselves come under liquidity pressure under current or worse market conditions, potentially forcing Sigma to rely on asset sales in a scenario of precipitous price declines. With respect to repos, counterparty asset prices are in some cases lower than those sourced by Sigma. This has the effect of reducing the amount of cash expected to be received by Sigma.
The other funding tool for Sigma is asset sales and the company has liquidated a total of US$9.5bn (excluding ratio trades) since June 2007. The sales have been representative of the asset portfolio in terms of industry and rating composition and, at 50bp below marks on average, trade execution has so far revealed robust pricing policies and procedures pursued by Gordian Knot. Nevertheless, the prices have themselves been declining steadily and, on occasions, precipitously since July 2007.
The average price that was 100.2% of par on 27 July 27 declined to 96.99% on 15 February 2008. As of 28 March 2008 portfolio market value was 95.59%. Sigma's net cash outflow profile up to 30 September 2008 shows that approximately US$20bn of debt must be financed using one or a combination of the above funding tools.
In addition, the company has committed liquidity of US$3.8bn in the form of bank facilities (US$1.5bn), breakable deposits (US$1.6bn) placed with a syndicate of Prime-1 rated banks, and puttable assets (US$688m).
The company's asset portfolio remains diversified and is of a high credit quality. Financial institutions comprise 59% of the portfolio, split into bank direct obligations 34%, bank holding companies 10%, captive finance companies 6%, investment banks 5%, monoline insurance companies 3% and insurance companies 1%.
The balance is made up of ABS, with the following important asset classes: CDO 15%, Prime UK, Dutch and Australian RMBS 11%, credit cards 5% and CMBS 5%. The portfolio has limited exposure to ABS CDOs and monoline wraps, and no direct exposure to US sub-prime RMBS.
The average life is fairly short at 3.48 years. In terms of credit quality, 44% of the portfolio is Aaa rated, 43% Aa rated, 9% A rated, 2% Baa rated and 1% rated Ba-B.
The company does not have market value or ratings-based enforcement triggers (except in the event of a withdrawal of all ratings). Instead, breaches of certain liquidity or capital adequacy tests would place the company into the 'no-growth' operating state. Sigma is currently operating in the no-growth state and has effectively been in this state since the beginning of August 2007.
Continued weakness in its liquidity position, crystallisation of mark-to-market losses or deterioration in portfolio credit quality could trigger entry into the 'natural amortisation' phase, whereby the company would be required to wind down following asset amortisations or redemptions. In natural amortisation, no payments are made to capital note investors and no performance fees are paid to the manager. Both operating states are reversible were the company to find more stable and dependable sources of funding in the future.
CDO credit migration analysed
The credit performance of CDOs showed some unprecedented deterioration in 2007, but deterioration almost wholly contained to a single sector – US dollar-denominated resecuritisations, reports Moody's in its annual CDO credit migration study. Outside of this sector, rates of rating downgrades in 2007 were lower generally than their historical averages.
"A review of the CDO market's credit performance in 2007 underscores its diversity," says Moody's svp Danielle Nazarian. "While sub-prime RMBS-backed resecuritisation CDOs underwent widespread and severe downgrades, other key CDO sectors performed well, including those tied to the US and European corporate credit markets."
In all, Moody's downgraded a total of 1,331 tranches of US dollar-denominated resecuritisations in 2007. These accounted for 92% of the 1,448 downgrade actions for all CDOs during the year.
Within the dollar-denominated resecuritisation category, downgrades were heavily concentrated in the 2006 and 2007 vintages. Actions from these two vintages alone constituted 87% of the 1,448 total downgrades.
Looking forward through 2008, the rating agency projects even greater ratings volatility among US dollar resecuritisation CDOs, as signalled by the nearly 2,000 tranches currently under review for downgrade.
The rates of downgrade in other sectors for 2007 were fairly comparable to those observed in 2006. The two exceptions were the market value CDO category – whose downgrade rate increased from 0% in 2006 to 7.5% in 2007 – and the investment grade arbitrage cash flow CBO sector, whose downgrade rate dropped from 10% in 2006 to 0% in 2007.
In this year's report, Moody's also examines for the first time cumulative downgrade ratings transitions for each vintage of CLOs from issuance through to the end of 2007. This analysis highlights the sector's long-term stability, as only one of the 589 CLO tranches assigned a Aaa rating at issuance has ever been downgraded.
CDO liquidations on the rise
As of 31 March, S&P reported 141 events of default (EODs) in SF CDOs, with all but two coming from the 2006/2007 vintages. By volume, US$157bn or 44% of 2006/2007 SF CDO issuance is in technical default.
Thirteen CDOs are reportedly currently in liquidation, while 15 deals have been liquidated. A total of 8% of 2006/2007 issuance is in some form of liquidation (14% mezzanine, 4% high grade and 12% CDO-squared). Those in the acceleration phase tally 16% (27% mezzanine, 11% high grade and 6% CDO-squared).
S&P says it has lowered its ratings on 33 classes of notes – worth US$3.6bn – from across four ABS CDOs (Ansley Park ABS CDO, Arca Funding 2006-II, Kefton CDO I and Markov CDO I) transactions to single-D. The rating actions follow notices from the trustees that the transactions have liquidated the portfolio collateral and have distributed or are in the final stages of distributing the proceeds to noteholders.
All four transactions had previously experienced EODs based on their failure to maintain EOD overcollateralisation ratios that were above minimum threshold values. The EOD overcollateralisation ratios for Ansley Park and Markov incorporate ratings-based haircuts.
The trustees for the four CDO transactions have indicated that they anticipate the proceeds from the sale of the collateral and in the principal collection account – along with any proceeds in the super-senior reserve account, CDS reserve account and other sources – will likely not be adequate to cover the required termination payments to the CDS counterparty, and that it is likely that proceeds will not be available for distribution to the notes junior to super-senior swap in the capital structure of the CDO transactions.
US ABCP programmes reduce CDO exposures
Traditional US ABCP programmes significantly reduced exposures to CDO and residential mortgage collateral throughout 2007 and into 1Q08, according to a Fitch analysis of its rated multi-seller and securities-backed ABCP programmes.
Results show overall exposures to CDOs and residential mortgage collateral contracting at a much faster pace than the overall ABCP market since year-end 2006 and non-mortgage consumer assets, along with corporate exposures growing substantially. Throughout the period, which has been marked by exceptional volatility and uncertainty, the ratings of these traditional ABCP programmes have proven stable – despite credit pressures across numerous sectors.
In addition to a dearth of mortgage and CDO originations in the current environment, the declines can be attributed to the termination and unwinding of ABCP programme types with high concentrations of these assets, as well as sponsors' proactive efforts to reduce or remove certain exposures in an effort to ease investor concerns in the current market environment.
Results of Fitch's portfolio composition analysis indicate total residential mortgage exposure declining by 59% on a dollar basis to US$9.4bn since end-2006. Over the same period, CDO exposures across Fitch's rated US multi-seller and securities-backed universe fell by 24% to US$13.9bn.
Student loans exhibited the largest increase in dollar terms, more than doubling to US$27.8bn, while corporate/commercial/bank exposures grew by 71.5%. Auto-related loans and leases jumped by 23% to US$37.5bn.
Overall ABCP outstandings have declined by more than 27% during the same period and 35% since peaking in July. Meanwhile, Fitch-rated multi-seller and securities-backed programmes increased approximately 4.7% on a like-for-like comparison since end-2006, with Fitch-rated multi-sellers growing 14.3%.
CPPIs downgraded
Moody's has downgraded six CPPIs: the Series 2007-19 and 2007-20 Greenwood Notes, and the Series 2007-22 Credit Pill 1 Notes from B1 to Caa1; the Series 2007-04 and 2007-23 Alpaca Notes from Ba3 to Caa2; and the 2007-24 Alpaca Notes from Ba3 to Caa1. The notes have been left on review for possible downgrade.
CPPI transactions protect the investment by only putting at risk a certain proportion of the proceeds from the sale of the notes. The remainder is available, at all times, to purchase a zero-coupon bond for the full principal repayment, should the rest of the proceeds be lost in the credit strategy. Therefore, the investors' principal is protected, but not their future coupons.
The Greenwood and Credit Pill transactions, issued by Magnolia Finance VI, are currently not invested in any credit strategy; the cushion amount available above the value of a zero-coupon bond is now small relative to its initial value. The Alpaca Series 2007-24 transaction still has proceeds invested, but currently the value of this investment is a small fraction of its initial value. Moody's believes there is significant probability that these four transactions will not pay all their coupons to the investors.
The Alpaca Series 2007-04 and 23, meanwhile, have permanently reverted to the zero-coupon bond and hence were rated taking into account the fact that no further coupon will be paid to investors.
S&P calls for greater transparency in leveraged finance
European investors are increasingly focusing on the true credit risk within their portfolio, but primary market prices have not followed suit, according to a report entitled 'A Call For Greater Transparency In The European Leveraged Finance Market' published by S&P.
"Against the backdrop of rising default risk, investors are increasingly looking for conservatively structured transactions, demanding covenant headroom of less than 25% and – crucially – appropriately priced risk," says S&P research analyst Taron Wade.
However, although there has been a very sharp repricing of risk in the secondary market in recent months, there has been only a limited change in primary pricing in the leveraged loan market. "We believe that the European market's failure to differentiate between loans according to credit quality in the primary market underlies the pricing imbalance," Wade adds.
It could be assumed that European primary margins are lower than those in the US because of an increase in credit quality across new issues, but the credit quality of new issues is in fact falling across Europe. In 2007, S&P assigned public ratings of single-B minus to 10% of issuers, representing a dramatic change in risk profile across the leveraged loan market compared with five years ago.
In the US, meanwhile, there has been a significant flight to quality, with prices moving very quickly and abruptly to reflect the change in demand – akin to the volatility seen in 1991. Risk-versus-reward prospects therefore seem much better for US investors, further emphasising the need for change in Europe.
Notably, new-issue US institutional spreads widened by between 75bp and 100bp in the second half of 2007. Moreover, the credit curve between double-B and single-B credits has steepened.
In Europe, however, institutional spreads only widened by between 40bp and 50bp in the second half of 2007. And the risk premium for buying single-B over double-B rated new issue paper had actually fallen to 16bp at year-end 2007, 5bp lower than in the six months to June.
Markit responds to the CMSA
In responding to the Commercial Mortgage Securities Association's letter regarding increased CMBX transparency (see last week's issue), Markit has made the following points. With regard to publishing daily volume data to assess the merits of using CMBX spread levels to value cash positions:
• As the CMBX trades on the OTC derivatives market, Markit does not have access to trading data (volumes and number of daily trades). It is therefore unlikely that the daily provision of trading volumes could be achieved nor the consistency of this data be guaranteed.
• Trading volumes have never been published for other OTC derivative products (e.g. rates, FX, commodities), apart from high level surveys conducted by ISDA.
Proposed EU regulation examined
FRSGlobal, provider of worldwide risk and global regulatory reporting solutions, has examined some of Commissioner Charlie McCreevy's key points on strengthening EU regulation.
• Disclosure regime change for structured products – The changes indicated are likely to result in increased frequency and volume of reporting in relation to structured product exposures.
• Roll up of special purpose entities – There are considerations as to whether the special purpose entities used in structured products should not be consolidated onto financial institutions' balance sheets. If such a proposal were to be made, the perceived standing of many institutions could change, even if in reality the economic impact is low.
• Changes on the definition of the significance of risk transfer – The fact that this has been mentioned suggests that the regulator is concerned with the current rules relating to when a securitisation has properly transferred risk. The likely impact of any change is a tightening of the current rules and the exclusion of some trades that are treated favourably under the current rules.
• New rules to limit the risk stemming from large exposure – The profile of large exposures allowed to be held by institutions will likely become more restrictive. The focus on understanding exposures and risk could also indicate more extensive reporting.
Selwyn Blair-Ford, senior regulatory domain expert, UK and Ireland, for FRSGlobal, says: "One should keep in mind that the key to this financial crisis is securitisations. Securitisations have the effect of weakening the traditional role of banks in the financing process, as it links funders to borrowers more directly."
He adds: "As a result, the exercising of monetary policy, either by increased liquidity or interest rate changes, has become less effective – especially when it operates solely on regulated banks. Central banks will need to address this problem and, consequently, an environment in which a wider range of institutions comes under their gaze is perhaps inevitable."
CIBC confirms participation in conduit plan
The Pan-Canadian Committee for Third-Party Structured ABCP has announced that satellite trusts of Structured Asset Trust (SAT) Series E and Structured Investment Trust III (SIT III) Series E have reached an agreement with CIBC concerning the termination of one of CIBC's CDS (related to SAT Series E) and the inclusion of CIBC's two other CDS (related to SAT Series E and SIT III Series E) as part of the Committee's Companies' Creditors Arrangement Act restructuring plan.
Reaching a mutually satisfactory agreement on the three swaps was a condition of CIBC's participation in the margin funding facility, which is integral to the Committee's restructuring plan. The agreement resulted from negotiations that began several months ago among CIBC and investors who own a substantial majority of the outstanding SAT Series E notes.
As part of the agreement, a CDS transaction with Nemertes Credit Linked Certificate Trust (Commerce - LSS II) Series 2006, which is a satellite trust of SAT, has been terminated. The termination resulted in a loss to noteholders of SAT Series E of approximately US$163m, or approximately 23% of principal. The maximum recovery of funds for SAT Series E investors as a result of this unwinding is now approximately 77%.
"We are pleased to see the successful restructuring of these swaps," says Purdy Crawford, chair of the Committee. "This restructuring is a long and complicated road comprising many steps, and [this] announcement represents further progress towards successful implementation of the overall restructuring plan."
CIBC is one of the financial institutions working with the Committee to resolve liquidity issues attached to the ABCP market in Canada and, together with a number of other Canadian Schedule I banks, has agreed – subject to certain conditions – to participate as a lender in the margin funding facilities that have been proposed upon implementation of the restructuring plan.
Under provisions of the Companies' Creditors Arrangement Act, the plan must be approved by a majority of noteholders (regardless of the size of their holdings) that vote at the meeting, as well as by noteholders representing not less than two-thirds of the total aggregate principal amount of affected ABCP that vote at the meeting. If the plan is approved by the noteholders at the meeting, a further hearing will be held before the Court for its final sanction of the plan.
IMF reports on sub-prime crisis
The widening and deepening fallout from the US sub-prime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF's latest Global Financial Stability Report (GFSR).
At present, the issuance of most structured credit products is at a standstill and many banks are coping with losses and involuntary balance expansions, the report says. The report examines this and other forces that could push the current credit crisis into a full credit crunch, as well as offering policy recommendations to mitigate the impact.
"Financial markets remain under considerable stress because of a combination of three factors," says Jaime Caruana, head of the IMF's monetary and capital markets department. "First, the balance sheets of financial institutions are weakening; second, the de-leveraging process continues and also that asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth."
The crisis has weakened the capital and funding of large systemically important financial institutions, raising systemic risks. Such financial institutions need to raise capital or cut back assets to cope with the strains, the report explains. The continued stress increases the downside risks for global financial stability and potentially forces institutions to further curtail credit, meaning that the macroeconomic effects could be severe.