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A round up of this week's structured credit news
Lehman-related downgrades reported ...
S&P has taken credit rating actions on 422 tranches in European securitisations following recent rating actions on Lehman Brothers Holdings Inc and related entities. Lehman performs a wide range of roles in various structured finance transactions, some of which have a bearing on the credit risk of the rated notes in the impacted transactions.
The rating actions affect the following number of tranches in each asset class:
• 243 RMBS;
• 22 ABS;
• 92 CMBS; and
• 65 CDOs.
The rating action breakdown is as follows:
• 381 ratings have been placed on watch with negative implications.
• Two ratings have been lowered.
• 22 ratings remain on watch negative.
• 17 ratings have been affirmed.
... while ratings are assessed by Fitch ...
Fitch is assessing the potential rating impact of the bankruptcy of Lehman Brothers Holdings Inc on synthetic CDOs that it rates. The agency has placed 23 tranches of CDO transactions on watch negative.
Lehman acted as CDS swap counterparty in 27 Fitch-rated public synthetic CDOs (and 35 private CDOs); 12 (17 private) in Europe; 15 (15 private) in Asia; and three private in the US. In many of these transactions, Lehman Brothers Special Financing acted as the buyer of credit protection from the CDO as CDS swap counterparty, and LBHI acted as a guarantor or credit support provider.
The impact on CDO note ratings where a Lehman entity acts as swap counterparty will depend upon many factors, including whether the swap may be transferred to another counterparty, whether the CDO transaction faces an automatic unwind following the Lehman bankruptcy and the extent to which noteholders may be subject to market value risk of eligible securities in the event of early termination of the transaction (see also separate news story). Should the swap counterparty, guarantor or credit support role not be taken over by another adequately rated institution, Fitch expects early termination events to be triggered, if not immediately, then within a 30 day timescale.
If an early termination is triggered where the swap counterparty is the defaulting party, the eligible securities would be either liquidated and used to repay the CDO notes before any swap termination payment is potentially due to LBHI, or would be delivered to the noteholders. In these instances, the CDO noteholders' risk profile may shift from the portfolio of reference entities to either the liquidation value or to the ongoing credit and market risk of the eligible securities. In the liquidation scenario, the CDO noteholders will either be paid in full from proceeds of the eligible securities or will incur a shortfall if the proceeds are less than the outstanding amount of the notes, plus any accrued and unpaid interest.
In the three private US transactions, collateral-posting arrangements were in place to cover any difference between the market value of the eligible securities and the outstanding balance of the notes, should early termination occur. In such cases, the loss to noteholders would be expected to be limited. For the remaining 27 (32 private) transactions, collateral-posting arrangements were documented to come into force only following the swap counterparty's, guarantor's or credit support provider's short-term rating being downgraded below F1.
Since it is not expected that LBHI will meet its collateral-posting obligations, should early termination occur, the noteholders would be subject to market value risk on the eligible collateral, and the noteholders may lose some portion of their investment, depending on the current market value of the eligible securities. As a result, Fitch expects that an early termination may result in the downgrade of the notes to the triple-C category or below, despite the fact that recoveries may be good to high in many cases.
... and DBRS
Lehman Brothers Holdings is referenced in 28 of the 80 Canadian CDO transactions monitored by DBRS. When rating CDO transactions, DBRS typically applies a fixed recovery rate in the range of 30% to 40% to all underlying corporate obligors, depending on the rating of the CDO tranche.
To demonstrate the level of ratings stability of the 28 transactions that reference Lehman, DBRS applied two stress scenarios: (1) assume immediate default by Lehman with 30% recovery; (2) assume immediate default by Lehman with 0% recovery. Both stress tests also incorporate the recent credit events of Fannie Mae and Freddie Mac, assuming a recovery rate of 95% for both companies based on current market indications.
For the scenario assuming 30% recovery for Lehman, the model results indicated that 24 of the 28 transactions were able to withstand this scenario while maintaining their current ratings. Of the four remaining CDOs, three were for issuers of multiple CDO tranches referencing the same portfolio, with different levels of enhancement and initial ratings.
For the scenario assuming lower recovery for Lehman, the model results indicated that 23 of the 28 transactions are able to withstand this scenario while maintaining their current ratings. Due to the zero recovery assumption, an additional transaction would be downgraded under the second scenario.
While the required subordination levels have increased for all of the CDOs with exposure to Lehman, most of the transactions still have sufficient subordination to withstand the stress scenarios applied. However, further ratings migration or losses from future credit events affecting the transactions may result in negative rating actions. For the deals requiring downgrades under the scenarios above, future rating actions will depend on the final recoveries of Lehman, Fannie Mae and Freddie Mac.
S&P revises CFO assessment
S&P has revised its assessment of the systemic risk that affects its analysis of transactions backed by the performance of funds of hedge funds or by a diversified pool of hedge funds (together CFOs), to reflect its view of higher market volatility combined with reduced liquidity in the hedge fund industry. Under this revised approach, no individual CFO transactions are eligible for a triple-A rating; the highest rating a CFO may now be assigned is double-A.
Notwithstanding the hedge fund of funds sector's historical performance, the agency believes that the sector remains vulnerable to the overall rise in market risk and more specifically the following factors:
• The recent increase in market price volatility and shortage of liquidity in previously liquid and stable economic sectors and markets, in S&P's view, is evidence that price stability and liquidity can cease to exist in periods of stress. In S&P's analysis, liquidity and price stability are crucial to the performance and ratings of CFOs, and problems in these areas are likely to be exacerbated during periods of high stress. The agency believes that in periods of stress commensurate with a triple-A rating environment, the systemic problems that would necessarily be present would also likely cause investors to seek to exit investments that are perceived to lack transparency, liquidity or price stability in search of safer alternatives.
• Hedge funds valuations and reporting can be inconsistent. When hedge funds invest in illiquid assets, the reported values of their investments are estimated, since market value depends on market liquidity. In periods of high volatility and illiquidity, the reported values of their assets become highly dependent on subjective estimates and assumptions of market prices that may not be fully achievable or not fully reliable.
• The performance correlation between hedge fund asset classes and investment strategies changes over time. In particular, during periods of heightened market stress, return correlations may increase significantly, thereby reducing the diversification benefits that have historically resulted in stable returns for hedge fund of funds portfolios.
Asian CDOs downgraded
S&P has lowered its ratings on 80 tranches relating to 56 Japanese synthetic CDO transactions and placed seven tranches relating to six others on watch negative. At the same time, the agency lowered its ratings on 74 tranches relating to 60 Asia-Pacific (ex-Japan) synthetic CDO transactions, 10 of which were also placed on watch negative. Ratings on four other tranches relating to Asia-Pacific (ex-Japan) synthetic CDO transactions were placed on watch with negative implications only.
The downgrades and watch placements reflect the impact on the relevant portfolios of several events that have occurred since the start of September: the placement of Fannie Mae and Freddie Mac under regulatory conservatorship; Lehman's Chapter 11 bankruptcy filing; and negative rating migration that reflects, but is not limited to, the downgrades and watch placements of AIG, BofA, WaMu and Tembec.
Primus counterparty rating on watch ...
S&P has placed its triple-B plus counterparty credit rating on Primus Guaranty on watch with negative implications. The listing results from the agency's expectation that the company will post weak economic results in the near-to-medium term as single-name credit entities held in its portfolio default and trigger losses.
Primus Financial Products, the company's triple-A rated derivative products company, is currently holding in its single-name credit default portfolio swaps referencing US$80m in Lehman Brothers Holdings obligations. Net losses on this single position will significantly hurt Guaranty's quarterly and year-to-date economic results.
Primus Financial may also take a small loss on a notional amount of US$215m in positions referencing Fannie Mae and Freddie Mac subordinated debt, since secondary market trading levels stabilised after the Treasury stepped in earlier this month. Prevailing market conditions and events also cause S&P to be wary of an increased general potential for defaults in the future.
The agency says it will resolve the listing before year-end as it assess the impacts of both realised and potential defaults on Primus Guaranty's economic results.
... while Fitch analyses overall CDPC exposure
Subsequent to the credit events experienced by Fannie Mae, Freddie Mac, AIG and Lehman Brothers Holdings Inc, Fitch has analysed the exposure to the affected reference entities in its portfolio of rated CDPCs. Given the subordination underlying the exposed tranches, the agency does not expect any reduction in the existing capital of these CDPCs, as a result of these credit events.
Fitch currently rates five CDPCs:
• Athilon Acceptance Corporation/Athilon Capital Corporation;
• Cournot Financial Products LLC;
• Invicta Capital LLC / Invicta Credit LLC;
• Quadrant Structured Credit Products LLC;
• Aladdin Financial Products LLC.
Within Fitch's portfolio of rated CDPCs, one or more of Fannie Mae, Freddie Mac, AIG and Lehman Brothers appeared in a total of 89 tranches, with an approximate reference notional as follows:
• AIG: US$2bn;
• Lehman Brothers: US$1.4bn;
• Fannie Mae/Freddie Mac: US$800m;
• Total: US$4.2bn.
Fitch says that is currently reviewing its rating criteria for CDPCs and will be communicating proposed changes to its methodology in the near future.
Nightingale Finance on review
Moody's has placed the senior debt ratings of Nightingale Finance on review for downgrade. Nightingale was restructured by the vehicle's sponsor, Banque AIG, in January 2008. Under the restructuring, CP and MTNs are fully backed by commitments provided by AIG FP.
Moody's notes that the Aaa ratings of Nightingale's medium-term note programmes depend jointly on the market value and credit quality of Nightingale's portfolio and on the ratings of AIG FP. Significant changes to either or both of these factors could result in a downgrade of the MTNs.
The Prime-1 rating of Nightingale's CP and MTNs relies on the short-term rating of AIG FP as provider of the senior note and repo commitments. Thus, if AIG FP's short-term rating were downgraded and a replacement facility provider not found, this could result in a downgrade of Nightingale's short-term rating.
The rating action follows the downgrade of AIG FP's long-term rating to A2 on review for downgrade and the placement of AIG FP's P-1 rating on review for downgrade on 15 September 2008. The rating action is also driven by the continued deterioration in market value of Nightingale's asset portfolio. The market value of the portfolio was 84% of nominal value as at 5 September 2008, compared with 96% on 23 January 2008.
Ambac and MBIA on review
Moody's has placed the Aa3 insurance financial strength rating of Ambac and the A2 insurance financial strength rating of MBIA on review for possible downgrade. The rating action follows Moody's announcement of an upward revision to cumulative loss projections for sub-prime RMBS exposures.
Moody's reviews of Ambac and MBIA will focus on the impact of increasing cumulative loss rate projections on each guarantor's mortgage-related exposures and risk-adjusted capital position. According to Moody's, lifetime cumulative losses on 2006 vintage sub-prime first-lien pools are now projected to average 22%, considering pool performance through the July 2008 remittance reports.
Projected losses increase progressively with the 2006 quarter of origination, averaging 17% for Q106 and rising to 26% for Q406. This compares to Moody's previous projections in January, which estimated losses in a range between 14%-18%.
Moody's says that because both Ambac and MBIA are meaningfully exposed to the risk of US sub-prime mortgages and other residential mortgage products, the revised assumptions are expected to have a significant impact on the firms' capital positions and multi-notch downgrades are possible. The agency will also evaluate the effect of changing loss-rate projections on its insurance financial strength ratings of other financial guarantors, including Syncora Guarantee Inc, FGIC and CIFG.
ISDA publishes deliverable obligation list
ISDA has published the first list of deliverable obligations to be included in the CDS Protocols for Fannie Mae and Freddie Mac. The first list of deliverable obligations will be supplemented and modified following comments from market participants. The Association expects to publish the final lists of deliverable obligations, along with the final version of the associated Protocols on 29 September.
Sub-prime losses calculated
Cumulative realised losses on sub-prime mortgage loans have reached US$50bn since the beginning of 2006, according to new JPMorgan structured credit research. From May through to August this year, the average monthly loss has been close to US$5bn - a significant increase from US$1bn on average for the same period last year.
The US$50bn loss figure equals slightly less than 10% of the worldwide write-downs of approximately US$520bn to date, and highlights how mortgage securities prices (ABX, cash bonds) have already incorporated expected future losses in sub-prime credit that will likely exceed US$300bn. The JPMorgan research indicates that realised sub-prime mortgage losses will continue, with accelerating liquidations, losses and loss severity (sub-prime loss severity is at 56% compared to 65%-70% implied by the market).
BIS reports on housing and hedge funds
The BIS has published two new working papers - one on the US housing meltdown and the other on hedge fund leverage.
The report on the housing meltdown examines how the boom-bust cycle in the US housing market differed from elsewhere and what the underlying institutional drivers of these differences were. Compared with other countries, it finds that the US seems to have: built up a larger overhang of excess housing supply; experienced a greater easing in mortgage lending standards; and ended up with a household sector more vulnerable to falling housing prices.
Some of these outcomes seem to have been driven by tax, legal and regulatory systems that encouraged households to increase their leverage and permitted lenders to enable that development. Given the institutional background, it may have been that the US housing boom was always more likely to end badly than the booms elsewhere.
The report on hedge funds describes how an extension of 'regression-based style analysis' and publicly available data on fund returns yield an indicator of the average amount of funding leverage used by hedge funds. The approach can take into account non-linear exposures through the use of synthetic option returns as possible risk factors.
The resulting estimates of leverage are generally plausible for several hedge fund families, in particular those whose returns are well captured by the risk factors used in the estimation. In the absence of more detailed information on hedge fund investments, these estimates can serve as a tool for macro-prudential surveillance of financial system stability.
Moody's reports on EOD-related downgrades
Moody's has withdrawn the rating of one class of notes, downgraded the ratings of 234 classes of notes issued by 57 ABS CDOs and left on review for possible further downgrade the ratings of two of these classes of notes. The rating actions reflect continuing deterioration in the credit quality of the underlying portfolios and the increased expected loss associated with each transaction. Losses are attributed to diminished credit quality on the underlying portfolio.
Moody's explains that each of the transactions has experienced an event of default (EOD) under the applicable indenture. As provided in Article V of the CDO Indenture, during the occurrence and continuance of an EOD, certain parties to the transactions may be entitled to direct the trustee to take particular actions with respect to the collateral debt securities and the notes. The severity of losses may depend on the timing and choice of remedy to be pursued by the controlling classes of investors.
CPDOs downgraded
S&P has lowered its ratings on 21 CPDOs, where they remain on watch negative. At the same time, Moody's has downgraded and left under review for possible downgrade 20 series of CPDO notes, both static and managed (see last week's issue for more).
The recent widening of credit spreads and the level of volatility in the credit derivatives market have been unprecedented, and this has resulted in further deterioration in the net asset values (NAVs) of these CPDO structures.
The rating actions reflect the increased risk that the NAVs may not be able to build value sufficiently for the structures to cash-in. In some transactions, the NAVs are close to trigger levels; if these are breached, it would lead to those transactions being unwound.
S&P says it is keeping all CPDO transactions on watch negative to reflect the volatility of credit spreads in recent weeks and the possibility of further market disruption.
GSE-related CDOs impacted
Moody's has downgraded 22 synthetic CDO tranches that have fixed recovery exposure to Fannie Mae and Freddie Mac. The action affects US$1.2trn of notional and the magnitude of the cuts range from one notch to as many as 10, though the median is four notches.
LSS notes downgraded
S&P has lowered and kept on watch with negative implication its ratings on various spread-based leveraged super senior (LSS) notes issued by Chess II (13 series of notes), Midgard CDO (1), Omega Capital Investments (1) and Saphir Finance (1). At the same time, the agency placed its ratings on Claris Series 64/2006, Eirles Two Series 337 and the Class B7E-1 notes of Omega Capital Investments Series 12 on watch negative.
The rating actions follow a significant widening in credit default swap spreads for the underlying reference obligors over recent weeks. For spread-based LSS transactions, this has led to an increased likelihood that a breach of the portfolio spread trigger might occur.
Furthermore, some of the transactions affected have suffered defaults in the underlying reference portfolio. Consequently, the note ratings have been lowered and remain on watch negative or are being placed on watch negative.
Spanish SME delinquencies deteriorating
Delinquency levels indicate that the most recent vintages are deteriorating more quickly than the older vintages in Spanish SME securitisations, says Moody's in its new Spanish SME Q208 Index report.
"Weighted-average 90-360 days delinquencies represented 0.75% of the outstanding balance of Spanish SME transactions at Q208, compared with 0.25% in Q207 and 0.28% in Q407," says Ludovic Thebault, a Moody's senior associate and co-author of the report.
A total of 58 Spanish SME ABS transactions rated by Moody's were outstanding as of Q208, with an outstanding pool balance of €37bn. Seven transactions experienced reserve fund draws over Q1 and Q2 2008, compared with only three experiencing reserve fund draws over Q3 and Q4 2007.
"Although Moody's has not yet taken any rating actions on existing SME transactions, in a deteriorating context, the outlook for performance remains negative, particularly for the most recent vintages," Thebault cautions.
Central banks coordinate ...
Ten central banks have announced coordinated measures designed to address the continued elevated pressures in US dollar short-term funding markets. The banks say that these measures are designed to improve liquidity conditions in global financial markets.
The Federal Open Market Committee has authorised a US$180bn expansion of its temporary reciprocal currency arrangements, which will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks until 30 January 2009. These larger facilities will now support the provision of US dollar liquidity in amounts of up to US$110bn by the ECB (an increase of US$55bn) and up to US$27bn by the Swiss National Bank (an increase of US$15bn).
In addition, new swap facilities have been authorised with the Bank of Japan, the Bank of England and the Bank of Canada. These facilities will support the provision of US dollar liquidity in amounts of up to US$60bn by the Bank of Japan, US$40bn by the Bank of England, US$10bn by the Bank of Canada, US$5bn by the Danish Central Bank, US$10bn by the Swedish Central Bank, US$10bn by the Reserve Bank of Australia and US$5bn by the Norwegian Central Bank.
... and SLS is extended
In view of the current disorderly market conditions, the Bank of England has announced an extension of the drawdown period for its Special Liquidity Scheme to provide additional time for banks to plan their access to the scheme in an orderly fashion. The drawdown period will now end on 30 January 2009.
The Bank says it will publish its consultation document on proposals for permanent reforms of its market operations at a later date. The features of the Scheme and the terms offered remain unchanged.
Resecuritisation approach revisited
The performance of loan pools underlying RMBS have experienced rapid deterioration, sometimes in as short a time period as a month. In light of these conditions, Moody's has announced that it will not assign a rating to any security issued by a resecuritisation transaction backed by one or more RMBS without first reviewing the ratings (and, if appropriate, taking rating actions) on the underlying RMBS, in addition to its normal surveillance of these underlying transactions.
Moody's says that this will be the case, even if the underlying RMBS ratings had been recently reviewed. The agency has undertaken and continues to undertake extensive and ongoing reviews of its ratings on US RMBS.
Moody's adds that the amount of time needed to complete any review of a rating of an underlying RMBS will depend upon many factors, including the nature and performance of the collateral pool, the complexity of the capital structure of the underlying RMBS, current market conditions and continued development of its methodologies and approaches for reviewing RMBS ratings.
CRE prices rise
Commercial real estate prices, as measured by Moody's/REAL Commercial Property Price Indices (CPPI), posted a small increase of 0.4% in July over the level measured in June, reports Moody's.
"This slight increase offers some relief from the steep declines of prior months, but may represent merely a temporary respite in a longer period of falling prices," says Moody's md Nick Levidy.
With the July increase, prices have decreased 9.7% from July 2007. The CPPI is now 1.1% higher than it was two years ago. Moody's notes that the largest decrease in prices among the annual indices examined was a 14% decline in the Florida apartment market, which also measured a decline in transaction volume in July.
Overall, commercial real estate transaction volume fell in July, after an increase in June. The July volume, however, was above the low-point reached in May.
Moody's/REAL Commercial Property Prices Indices are based on the repeat sales of the same properties across the US at different points in time. Analysing price changes measured in this way provides maximum transparency and methodological rigour. This approach also circumvents the distortions that can occur with other commercial property value measurements such as appraisals or average prices, says Moody's.
JASME to guarantee deposit refunds
Japan Finance Corporation for Small and Medium Enterprise (JASME) has announced that it will guarantee the financial institutions' obligations for deposit refunds to issuers (SPC) in three transactions - Tanpopo 2007, Cosmos 2007 and Tanpopo 2008. The guarantee will not affect to their ratings, however.
The affected deals are synthetic CLO transactions referencing corporate loans for SMEs originated by financial institutions with the intention of securitising them under JASME's 'purchase scheme' programme. The note proceeds issued by the SPC are deposited in the non-interest bearing ordinary bank accounts of each financial institution, based on the deposit agreement between them and the SPC. The deposits will be used for credit protection payments under the CDS and principal payments on the notes.
JASME will be merged with National Life Finance Corporation, Agriculture Forestry and Fisheries Finance Corporation, and Japan Bank for International Cooperation in October 2008. The new entity will be called the Japan Finance Corporation, and will assume JASME's guarantees.
QWIL reports net profit
Queen's Walk Investment Ltd has reported net profit of €0.8m or €0.03 per ordinary share for the quarter ended 30 June 2008, compared to a loss of €17.1m or -€0.56 per share in the previous quarter. The company's cash position remained strong with approximately €35.9m of cash on its balance sheet, up from €32.9m as at 31 March 2008. Cash generation for the quarter was in line with forecasts, with total cash proceeds recorded from the investment portfolio in the quarter of €12.3m.
Fair value write-downs of the company's investment portfolio were significantly lower in the quarter, totaling €4.1m compared with €22.1m for the quarter ended 31 March 2008. The company's net asset value at quarter-end was €6.32 per share compared to €6.42 per share in the previous quarter.
OTC Val expands into illiquids
Independent derivatives valuation provider OTC Val has expanded its securities coverage to address valuation for illiquid mortgage, credit card and bank loan related products. To accommodate audit and internal risk compliance requirements for securities with no market observable prices, the firm is working with market participants to address their valuation and transparency requirements by employing model-based and fair value estimation techniques.
Bob Sangha, md at OTC Val, says: "In an inactive market, we believe that market participants are as concerned about the assumptions and data behind a product's price as the price itself. Our valuation methods enable us to provide this level of transparency and disclosure. In addition, we employ a variety of reasonableness tests to ensure consistency and accuracy, while utilising [FAS 157 Level II] observable market inputs where possible."