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A round up of this week's structured credit news
Dealers net long credit
DTCC has begun publishing weekly aggregate market data from its Trade Information Warehouse. The data includes the outstanding gross and net notional values of CDS contracts registered in the Warehouse for the top 1,000 underlying single name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency, the clearer says.
Credit Derivatives Research has released a 'first cut' analysis of the DTCC's Trade Information Warehouse data for the week ended 31 October. Aggregating at the reference entity type, the analysis shows that dealers are generally (long credit) net sellers of protection (in order of gross notional magnitude) in consumer services, financials, industrials, consumer goods, basic materials, technology/telecoms, sovereigns, oil & gas, healthcare and CMBS. Non-dealer/buy-side participants are (long credit) net sellers of protection (in order of gross notional magnitude) in LCDS, utilities and 'other'.
Financials are the largest gross notional exposure, followed by consumer services and consumer goods. CMBS, LCDS and RMBS are the lowest gross exposures, with healthcare, oil & gas and utilities the lowest in the corporate space.
"Reading much into this is tough as these are gross and not net notionals, but it is interesting to see that dealers are still net long credit in general (with their traditional pos-carry, steepener, roll-down positions probably intact, despite the deleveraging)," CDR analysts note. "As we might expect, dealers are net buyers of LCDS protection (hedging their loan books), but being net short utility credits is perhaps more related to the concerns over refinancing stress and hedging that risk (on the side of dealers)."
The DTCC data also breaks down gross and net notionals at the single name level, with the largest net notional exposures based on sovereigns (Italy, Spain, Brazil, Germany, Russia, Greece, Turkey, Korea and France are all in the top 20). The rest of the top 20 are financials: Deutsche Bank, GECC, Morgan Stanley, Merrill Lynch, Goldman, Countrywide Home Loans and Citi.
Based on the data, CDR estimates a total gross notional of around US$15trn, which nets down to under US$2trn of total global exposure.
The DTCC data is shown in two sections. Section 1 shows the outstanding notional values at a given point in time (the end of each week). Section 2 shows data relating to the weekly confirmed trade volume, or 'turnover', with respect to the same underlying reference entities and indices, as well as similar aggregations of such data. Section 2 data will be published beginning the week after the initial publication of outstanding notional values.
Housing prices to reach bottom?
The market has woken up to the inevitability of principal forgiveness as the way forward in finding a bottom for housing prices, according to structured finance analysts at JPMorgan. "In our view, the sooner the outstanding debt levels are re-aligned with the value of the core underlying asset, housing, the sooner home prices can stabilise and economic growth can return to sustainable levels," they note.
The analysts add: "To help smooth the process, the government seems likely to provide some form of mortgage insurance to debt once a lender has provided at least partial principal forgiveness or forbearance to the borrower. For MBS investors, two realities are emerging. Bond cashflows will be altered in a meaningful way; and moral hazard and legal risks are escalating." At a minimum, timing of collateral losses is likely to be accelerated.
In sub-prime, to the extent the modification is loss-neutral, the acceleration of loss recognition should benefit last cashflow senior tranches at the expense of current pay tranches, as principal payments have greater likelihood of shifting to pro-rata allocation. Moral hazard risk likely will impact higher quality mortgages, the analysts say, as borrowers who may otherwise not have defaulted now feel like that may be the optimal economic course to address negative equity positions.
JPMorgan announced a restructuring plan for US$110bn troubled US mortgages on Friday, which aims to avoid foreclosures by reducing mortgages interest rates or principal amount. 400,000 families should benefit from this plan and other large US mortgage houses are expected to follow suit.
Moody's reports on CDS market
The bankruptcy of Lehman Brothers has put the CDS market to an unprecedented test and has resulted in losses in the hundreds of millions dollars for a number of Moody's-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any rated company to date, Moody's says in a new report. However, the agency also sees the possible failure or failures of other large CDS market participants as a continuing source of systemic risk. In Moody's opinion, it is highly unlikely that the CDS market would have been able to deal effectively with a simultaneous default by AIG - probably the largest net seller of CDS protection.
A survey conducted by Moody's of the major Moody's-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated. "Lehman's bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unravelling of the CDS market," says Moody's avp/analyst Alexander Yavorsky.
Still, he adds that the emergency unwinding of Lehman's CDS book by major dealers and hedge funds though a risk reduction trading session on the weekend preceding Lehman's anticipated bankruptcy filing demonstrates that the OTC CDS market is "ill-equipped to reliably deal with such events".
Given Lehman's role as a major CDS dealer, its default and the resultant credit spread widening left its CDS counterparties needing to replace lost protection at much higher prices. For a number of the major CDS dealers, this resulted in losses that, while substantial, did not fall outside of the range that could be tolerated at any company's rating level at the time.
Moody's notes that major dealers also did not suffer losses in excess of their ratings-tolerance on CDS contracts referencing Lehman Brothers as an obligor, despite the low auction-determined settlement price of 8.625 cents on the dollar for Lehman's senior bonds. "Many dealers had flat or net short CDS exposure to Lehman's credit as a way to hedge their counterparty exposure to the firm," Moody's Yavorsky explains.
The report also discusses what Yavorsky characterises as "encouraging progress" among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks. It could also impose economic limits on effective leverage and excessive credit exposure by requiring protection sellers to post appropriate initial margin.
S&P MCRS reports on valuations
The market, credit and risk strategies group (MCRS) - S&P's newly-formed, separate and independent research team - has released a report entitled 'Valuing Structured Finance Assets 101: What Are These Things Really Worth?' The aim of the study is to cut through the rhetoric surrounding the valuation of complex securities by focusing on their cashflows, credit risk and 'risk of ruin'.
According to the MCRS team: "The difference between carrying a mid-tier RMBS on the balance sheet at 80 cents on the dollar and less than 10 cents on the dollar can be as little as a 5% difference in assumptions over future default rates."
A central challenge currently facing global investors is the appropriate and fully disclosed pricing of, and the risks associated with, Level 3 assets - also known as mark-to-model assets. The MCRS team believes these assets can be valued in a meaningful and transparent manner that is largely dependent on investors' perceptions of current and future credit risks. To show how this can be done, it conducted a case study that sheds light on the difficult and complex, but not insurmountable, nature of valuing esoteric structured finance Level 3 assets.
Among the team's key findings was that not all RMBS tranches are created (i.e., structured) equally. While some deserve serious consideration by even the most risk-averse money managers, others should be avoided by all but the most sophisticated institutional investors.
While structured finance assets can be difficult to price due to the multiple input variables that must be considered and modelled, investors can nonetheless price them in a transparent and meaningful way. In true 'buyer-beware' fashion, investors should individually determine an appropriate valuation for each risk factor associated with a given structure by analysing multiple factors drawn from a pool of existing market conditions, and assumptions about future conditions in the credit and real estate markets.
This is akin to an equity investor determining the appropriate price/earnings valuation assumption that should be assigned to the equity market, the report says. As in any distressed auction, the bidder with the most optimistic assessment of future valuations will submit the winning bid.
Further CRE CDO buyback
Concord Debt Holdings, a joint venture debt platform among Winthrop Realty Trust and a subsidiary of Inland American Real Estate Trust, has repurchased US$2m of the Class E bonds and US$2m of the Class F bonds issued by Concord Real Estate CDO 2006-1 for an aggregate price of US$1m, representing a discount of approximately 74%. In July mortgage REIT Gramercy Capital bought back US$37.8m of CRE CDO bonds that it had previously issued, generating gains of US$17.6m in the process (see SCI issue 99).
Landsbanki price determined
Creditex and Markit, in partnership with 14 major credit derivative dealers, have determined a price to facilitate the settlement of credit derivative trades referencing the debt of Landsbanki Islands in Europe's first-ever credit event auction. The final price for Landsbanki senior debt was determined to be 1.25% and 0.125% for subordinated debt.
The auction was conducted in accordance with the ISDA 2008 Landsbanki CDS Protocol. Creditex and Markit will conduct credit event auctions to facilitate the settlement of CDS contracts referencing Glitnir Banki today, 5 November, and Kaupthing Banki on 6 November.
ISDA applauds industry operational efforts ...
ISDA has applauded a number of industry initiatives that have had the beneficial effect of reducing notional amounts outstanding in CDS, significantly reducing operational, legal and capital costs for industry participants and improving operational efficiency in the market. In 2008 efforts to reduce notional outstanding amounts have been rewarded by a decrease of over US$25trn in CDS notionals, reflecting a range of activities, including compression exercises run by Trioptima, Creditex and Markit.
This year to date, Trioptima has reduced by US$24.5trn the amount of CDS notional outstandings through its series of compression cycles (also known as tear-ups), which have included index, tranche and single-name trades. Additional efforts implemented by Creditex and Markit that focus on the single name space began as recently as September and now account for US$550bn in compressions.
According to ISDA's semi-annual survey to mid-year 2008, the notional amount outstanding of CDS decreased by 12% in the first six months of the year to US$54.6trn from US$62.2trn. For the same period, Trioptima reported US$17.4trn in completed CDS tear-ups. Subsequent notional reductions would bring CDS notional outstandings to US$46.95trn before accounting for new trades since 1 July 2008.
... and submits operations letter to the Fed ...
ISDA - together with the Operations Management Group, the Managed Funds Association and SIFMA - has submitted a letter to Timothy Geithner, president of the New York Fed, in an effort to improve derivative market processing and scalability, as well as augmenting risk mitigation and transparency. The ISDA initiatives outlined in the letter include: CDS auction hardwiring; conferences in New York, London, Sydney, Tokyo and Hong Kong to promote awareness of industry commitments in respect of operations matters; and the release of various best practices and guidance notes, relating to individual asset classes and collateral matters.
... while further CDS portfolio compressions are undertaken
Four industry-wide CDS portfolio compression runs were completed in North America and Europe last week, report Creditex and Markit. Compression runs were completed in North America for CDS contracts referencing consumer products companies and in Europe for CDS contracts referencing industrial, energy and utilities companies as well as European sovereigns. Compressions carried out across a total of 61 reference entities achieved a gross notional reduction of 44%, or US$150bn, across all participating counterparties.
Meanwhile, TriOptima says it has offered 39 compression cycles since the beginning of the year and will offer nine additional compression cycles in November and December.
Asian ...
S&P has downgraded the ratings on 92 tranches of Asia-Pacific (ex-Japan) synthetic CDOs, of which 66 were also placed on credit watch with negative implications. The agency has also lowered its ratings on 93 tranches relating to 66 Japanese synthetic CDO transactions and placed its ratings on 13 tranches relating to 12 deals on watch with negative implications. The rating actions reflect its revision of certain assumptions, including industry classifications and correlation assumptions, which are applied to the financial services sector in rating CDOs and CDS.
The downgrades and watch placements follow several recent events: Washington Mutual's Chapter 11 bankruptcy filing; the appointment of receivership committees for Kaupthing Bank, Landsbanki Islands and Glitnir Bank; the auction results of ISDA's protocol being taken into consideration for the evaluation of Fannie Mae, Freddie Mac, Lehman Brothers Holdings, Tembec and WaMu; and negative rating migration of reference entities.
... and European CDOs hit
S&P has also taken credit rating actions on 77 European synthetic CDO tranches. Specifically, the ratings on 57 tranches were lowered, and 20 tranches were lowered and remain on watch negative. Of the 57 tranches lowered, 35 reference US RMBS and US CDOs that are exposed to US RMBS that have experienced recent negative rating actions; and 22 have experienced corporate downgrades in their portfolios.
The rating actions include the following recent developments: revised correlation assumptions for CDOs that reference financial intermediaries; assumed recovery valuations of 91.51% for senior Fannie Mae debt and 99.9% for subordinated debt; assumed recovery valuations of 94% for senior Freddie Mac debt and 98% for subordinated debt; and assumed recovery valuations of 8.625% for Lehman Brothers debt. S&P says it will continue to review transactions that reference Fannie Mae, Freddie Mac, Lehman and other credit events, and will update the ratings in due course.
Synthetic schuldscheine launched
Moody's has assigned Aa3 ratings to two credit-linked schuldscheine issued by LBBW and due in 2015. Though the issuance size is very small - at €2m and €14m - the deals represent an interesting new twist on the use of schuldscheine in securitisations (see SCI issue 97).
According to Moody's, the transactions are synthetic CDOs referencing corporate and sovereign entities, comprising 2.5% thick tranches with 4% subordination. Substitutions of the underlying portfolios may be made by LBBW, but require consent of the creditors. The deals allow trading gains or losses to adjust the subordination.
Counterparty credit deterioration threatens HFA issuance
The credit deterioration of counterparties and the current global credit and liquidity crisis have heightened the risks associated with variable rate bonds issued by housing finance agencies (HFAs), says Moody's in a new report. The proceeds of HFAs bonds are used to finance mortgage loans for low- and moderate-income borrowers.
"In some cases, disruption in the short-term debt markets has resulted in an inability to remarket variable-rate demand bonds, exposing some programmes to higher interest rates and possible acceleration of principal repayments," says Moody's analyst Omar Ouzidane, author of the report. "Failed re-marketings have led to payments by banks under liquidity facilities for tendered bonds resulting in what are known as bank bonds, which may have higher interest rates than the bonds in the primary market and many require a more rapid bond principal amortisation, possibly diminishing an HFA's available funds and weaken its financial performance."
Recent downgrades of several counterparties, most notably Depfa Bank and to a lesser extent Dexia Credit Local, have led to a substantial increase in bondholder tenders of variable rate demand bonds that have not been successfully remarketed.
"The current global credit and liquidity crisis have resulted in the downgrades of some of the HFAs' counterparties, including liquidity providers and swap providers," adds Ouzidane. "Material exposure to a swap or other counterparty facing credit stress could result in swap termination payments, placing strains on the affected HFAs' balance sheets." Both Lehman Brothers Derivative Products and AIG Financial Products were active in providing swaps to HFAs.
"Though the usual real estate risks, including higher delinquency and foreclosure rates, remain manageable because most programmes have sufficient resources to mitigate these risks, the downgrades of the counterparties may put pressure on those resources and challenge future profitability," continues Ouzidane. "Moody's has created a framework to identify the emerging credit challenges faced by each HFA bond programme and will undertake an assessment of each HFA programme."
Factors which might mitigate identified risks, such as substantial fund balances or large amounts of liquidity, are currently being assessed, and are not reflected in the portfolio scoring reported in the article. Consequently, Moody's says, it is possible that the actual impact on some HFAs may be different from the perceived impact.
"Many of the HFAs have adequate liquidity, strong management and plans in place to weather the current market turmoil," concludes Ouzidane. "Where that is not the case, Moody's will take appropriate rating action and update the market on further developments."
S&P reports on Athilon ...
S&P has released a transaction update on Athilon Capital Corp/Athilon Asset Acceptance Corp and has placed the CDPC's issuer credit rating on credit watch negative. The rating action is based on S&P's stressed scenarios analysis on the company's exposure to certain ABS assets. However, the rating action will not cause Athilon to post collateral to the counterparties because its operating guidelines don't permit it to enter into swaps that require it to post collateral.
... and 47 Quay
S&P has withdrawn its AAA/A1+ counterparty credit rating on 47 Quay and the preliminary ratings on the senior/junior mezzanine floating-rate (AAA/AA) and senior/junior capital notes (A/NR) issued by the CDPC. The action follows 47 Quay Capital's withdrawal of its CDPC vehicle and issuer transactions.
Troubled companies index deteriorates sharply
Kamakura Corporation reports that its index of troubled public companies deteriorated in October at the sharpest rate since the index began in January 1990. The Kamakura global index of troubled companies jumped by a record 5.6% from 16.4% of the public company universe to 22% of the universe during the month. This is the highest level reached by the index since January 2003, and it comes close to the 28% all-time high in the index, recorded in September 2001.
The Kamakura index has now shown declines in credit quality in 14 of the last 15 months. At the 22% level, the index shows that credit conditions are better than only 8.1% of the monthly periods since the start of the index in January 1990. The all-time low in the index was 5.4%, recorded in April and May 2006.
Kamakura defines a troubled company as a company whose short-term default probability is in excess of 1%. The index covers more than 21,000 public companies in 30 countries using the fourth-generation version of Kamakura's advanced credit models.
"The wide-spread recognition that a severe recession is underway affected the corporate universe across the board," comments Warren Sherman, Kamakura president and coo. "Among rated public companies, Anglo Irish Bank Corporation, Bank of Ireland, Citadel Broadcasting Corporation and Thomson (of France) showed the greatest rise in short-term default probabilities during October."
New CDS ETFs launched
Deutsche Börse has launched four new credit derivative exchange-traded funds (ETFs) - which make the iTraxx benchmark indices tradable in the format of UCITS III funds - issued by db x-trackers II on the pan-European Xetra trading platform. The iTraxx Europe Subordinated Financials 5-year TRI ETF and the iTraxx Europe Subordinated Financials 5-year Short TRI ETF are based on Markit's iTraxx Europe Subordinated Financials 5-year Total Return Index (see SCI issue 109). The iTraxx Europe Senior Financials 5-year TRI ETF and the iTraxx Europe Senior Financials 5-year Short TRI ETF are based on Markit's iTraxx Europe Senior Financials 5-year Total Return Index.
The two long ETFs measure the return for a credit protection seller of holding iTraxx Europe Financials credit derivative transactions with a tenor of five years. The underlying indices comprise the subordinated and senior debt respectively from the 25 finance companies referenced in iTraxx Europe index. With the two short products, on the other hand, investors participate in the development of the return for credit protection buyers.
The management fee for the first two ETFs is 0.21%, while it is 0.18% for the second two.
Central counterparty novation of existing CDS "essential"
Structured credit strategists at UniCredit suggest that the novation of existing CDS trades to a new central counterparty is essential, in particular for single name short protection CDS. "Without knowing the details of the complex margining models, it seems that a diversified portfolio of single name CDS is necessary to avoid disproportionate margin calls," they note.
The strategists warn that a suitable margining of single name CDS is harder to determine than for index CDS, adding that whether the market is willing to switch to a fixed-coupon contract for such instruments remains unclear.
Mixed week for ABX
Analysts at Barclays Capital note that the Markit ABX index had a mixed week last week - rallying at the top of the capital structure, while selling off at the bottom. PAAAs/AAAs rallied by up to one point across indices and BBBs/BBB-s fell modestly across all vintages.
"Overall, the market-implied risk premium compressed by 121bp, reflecting the strong performance of the 06 vintage PAAAs and AAAs," the analysts observe. "However, overall market-implied loss expectations increased across all indices by almost 1%."
Project finance CDO launched
Sirrah Funding II, a senior-subordinate cash CDO of project finance and utility bonds, has closed. The deal, arranged and retained by Hypo Real Estate and managed by Depfa, is rated by S&P.
The transaction is not the first of its type, although there have not been many portfolios focused solely in these sectors. S&P notes that the asset analysis is more bespoke, focusing more on the relationships between the sectors and sub-sectors than a diverse portfolio would warrant, as well as the impact that bond characteristics of these sectors have on the liability structure.
Curzon MTNs downgraded
Moody's has downgraded the MTNs issued by Curzon Funding to Aa3 from Aaa on review for possible downgrade. Curzon Funding is a credit arbitrage ABCP conduit that is able to issue ABCP and several different types of MTNs, including conventional notes and non-credit linked structured notes. Its rated liabilities are fully supported by total return swaps provided and guaranteed by Curzon's sponsor, AIG Financial Products Corp.
The ratings of the notes were placed on review for possible downgrade on 16 September 2008, following the downgrade of AIG and AIGFP to A2 on review for possible downgrade from Aa3 and the placement on review for possible downgrade of their Prime-1 issuer ratings. The long term ratings of AIG and AIGFP were further downgraded to A3 on 3 October 2008 and remain on review for possible downgrade.
Moody's also placed the Prime-1 rating in respect of the ABCP issued by Curzon on review for possible downgrade on 16 September 2008.
Pursuant to the terms of the TRSs, the first downgrade resulted in a requirement for AIGFP to post collateral (or take other remedial action) within 30 business days. On 14 October AIGFP executed a credit support annex (CSA) for each TRS and posted collateral in an amount equal to the nominal/face amount of the notes plus, in the case of interest bearing notes, six months' of interest.
As part of its ongoing review, Moody's is investigating whether, following an insolvency of AIG, Curzon will be legally entitled to access the entire amount of collateral posted under the CSAs in order to repay the notes, as well as the potential impact on loss severity associated to index-linked products .
ABS issuance to increase in 2010
A new report from Wachovia Capital Markets highlights that the credit crunch is the first serious test of the ABS market. Securitisation of consumer assets was still in its infancy during the last credit crunch of 1990-1991 and the rapid growth of securitisation as a financing tool was in part a response to that contraction of credit.
"As households work to repair their own balance sheets, consumers and mortgage debt outstanding is likely to fall. This should translate into a smaller ABS market in 2009, but an increase in 2010," structured finance analysts at the bank note.
ECB hosts CCP meeting
The European Central Bank (ECB) has hosted a meeting with European stakeholders concerning the establishment of central counterparties (CCPs) for CDS. Participants included the potential providers of such CCPs, their regulators and the main users (dealers and buy-side). The meeting complemented initiatives by the Federal Reserve Bank of New York and the European Commission in this field.
The Eurosystem shares the views of the Financial Stability Forum and of the European Commission on the importance of reducing counterparty risk and of enhancing transparency in OTC derivatives markets, especially in those parts of the market that are of systemic importance (e.g. credit derivatives). The Eurosystem sees the introduction of CCPs for OTC derivatives as an appropriate solution to tackle the aforementioned issues because CCPs, by virtue of concentrating outstanding positions in one place (i) reduce the counterparty risk to which market participants are exposed; (ii) increase market integrity, transparency and the availability of information; (iii) standardise the criteria for evaluation of exposures; and (iv) free up collateral.
Participants at the meeting underlined the merits of multiple solutions in general and of at least one European solution.
Fitch reports on Chinese ABS
Fitch reports that China's securitisation market is moving forward gradually, despite the complex domestic environment and the current global financial crisis. Although regulators have made efforts to advance the market's development, and steady progress of the second batch of pilot programmes is noticeable, corporate ABS - which is thought to have the most potential in the country - is missing from the picture.
The low liquidity of securitisation notes in the interbank market, mainly as a result of investment restrictions by regulators, is another concern for market development. However, the agency expects an additional securitisation transaction to be issued in 2008, and another round of formal reviews on the market by regulators to follow.
ISE increases transparency
The Irish Stock Exchange has taken measures in response to market concerns around transparency and particularly the provision of all documentation on one website which is easily accessible to market participants. The exchange is to invest resources in ensuring that its website can be used as a best-in-class access point for all investors to gain more information on securities issued and related documentation.
The new transparency service offering by the exchange is available for all issuers with securities listed on the ISE. Issuers can now publish investor reports, transaction documents and financials on the ISE website.