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A round up of this week's structured credit news
CDS liquidity scores introduced
Fitch Solutions has created new liquidity scores and percentile rankings for widely-traded credit derivative assets to help banks identify their exposure to the most liquid and least liquid assets, as well as strengthen their liquidity risk management procedures. The scores cover over 3,000 of the most widely-traded CDS assets. Each asset is assigned a score, representing the most through to least liquid names, and then given a global percentage ranking according to its liquidity profile against the overall CDS universe.
"Given the market focus on liquidity risk and recent Basel Committee guidance, understanding the relative liquidity of assets is critical for banks in assessing how they fund their short-term liabilities and helping them to meet regulatory commitments," says Thomas Aubrey, md, Fitch Solutions, London. "For the first time, risk managers will be able to compare the relative liquidity of assets across regions, sectors and rating bands, as well as having information on the liquidity of an asset and the broader CDS market over time."
The initial launch is open to member banks of Fitch's global pricing services consortium that provide it with pricing information on a variety of structured finance and fixed income derivative assets. The launch will be extended to buy-side market participants in the New Year.
Fitch has also published new research on liquidity risk in the CDS market which highlights that liquidity does not necessarily worsen as credit quality worsens; that the CDS market has in general become more liquid despite many assets becoming less liquid; and that specific credit events play a key role in determining the liquidity of an asset.
Credit event for Hawaiian Telcom, Masonite auction date set
LCDX dealers have voted to hold an auction for loan-only CDS transactions referencing Hawaiian Telcom Communications Inc, which announced this week that it has filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the US Bankruptcy Court for the District of Delaware in Wilmington. ISDA will facilitate the process by publishing the auction terms, including the auction date, in the next few weeks.
The auction terms will set out a settlement mechanism, which - unlike those used to settle recent credit events including Lehman Brothers and Washington Mutual - is already built into ISDA's standard loan-only CDS documentation, therefore no protocol is required. This will be the third time the auction has been used to settle loan-only CDS contracts, the first being Movie Gallery in October 2007 and the second being Masonite - the auction for which is scheduled for 9 December. Both auctions will be administered by Markit and Creditex.
RAM Re commutes MBIA exposure
RAM Reinsurance Company has entered into a commutation agreement to commute its entire US$10.6bn portfolio of business assumed from MBIA Insurance Corp and affiliates. The agreement is effective upon receipt by MBIA of a commutation payment of US$156.5m, which includes the return of US$51.5m of unearned premium reserves (calculated on a US statutory basis) and US$61.3m of estimated loss reserves and impairments (a non-GAAP measure) as of 30 September 2008.
The commuted portfolio of US$10.6bn par outstanding consists of:
• US$6.8bn par of structured finance transactions, including US$439.3m of CDS written on ABS CDOs, US$2.4bn of CMBS CDOs and US$453m of 2005-2008 vintage US RMBS
• US$3.8bn of public finance transactions, including US$1.2bn of international public finance transactions.
As of RAM's 30 September 2008 financial information, the commuted portfolio represented approximately:
• 98% of RAM's total unrealised losses on ABS CDO credit derivatives contracts
• 100% of total par outstanding of ABS CDOs, for which RAM has established credit impairments
• 37% of total loss reserves for RMBS transactions
• 45% of total par outstanding of RMBS, for which RAM has established case reserves
• 99% of total par outstanding of CMBS CDO transactions.
Vernon Endo, RAM's ceo, comments: "This commutation represents another milestone in RAM's efforts to restructure its insured portfolio. As a result of the MBIA commutation, we have reshaped our insurance portfolio by reducing our overall exposure to ABS CDOs and 2005-2008 vintage US RMBS by more than 64% and 27% respectively. After the commutation, US public finance exposure will increase from 51.3% to 60.1% of our portfolio."
Sigma MTNs downgraded
Moody's has downgraded Sigma Finance's Euro and US MTN programmes from Ca/Not Prime to C/Not Prime, affecting US$5.9bn of debt securities. Moody's says that, following further price declines since September 2008 when repo counterparties served notices of default to Sigma, recovery of any margins from repos now appears unlikely. In addition, the receiver conducted an auction of US$2bn of assets (reportedly mostly US CDOs) held by Sigma earlier this week. In Moody's view, the likely recovery value for MTN investors is consistent with a rating of C.
Basel Committee gives guidance on fair value ...
The Basel Committee on Banking Supervision has issued a consultative paper entitled 'Supervisory guidance for assessing banks' financial instrument fair value practices', which aims to help strengthen valuation processes for financial instruments. The main principles behind the guidance include: strong valuation governance processes; use of reliable inputs and diverse information sources; independent verification and validation processes; communication of valuation uncertainty to internal and external stakeholders; consistency in valuation practices for risk management and reporting; and strong supervisory oversight around bank valuation practices.
The guidance supports one of the key recommendations for enhancing transparency and valuation set out in the April 2008 report of the Financial Stability Forum on enhancing market and institutional resilience. Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, says that this work "is part of a broader effort by the Committee to strengthen firm-wide risk management practices. This guidance will help supervisors assess the rigour of banks' valuation processes and promote improvements in risk management and control practices".
... and focuses on the audit function
The Basel Committee on Banking Supervision has released a paper that summarises its key areas of focus regarding the audit function:
• Bankers' and supervisors' reliance on external auditors' expertise and judgments has increased
• High-quality audits, which enhance market confidence, particularly in times of severe market stress
• An increasing reliance on high-quality bank audits to complement supervisory processes
• The globalisation of major external audit firms has contributed to the complexity of their structures and a lack of transparency regarding their governance.
The Committee says it intends to build upon its ongoing efforts to address audit quality through continued support of groups with direct influence over external audit firms and promotion of enhanced sound audit guidance, practices and standards. It also calls for enhanced transparency over the structure and financial positions of global network audit firms.
In recent years, there has been a change in banking supervisors' reliance on audited information and in the nature of the major external audit firms, the Committee notes. The need for bank supervisors to be confident of audit quality has been reinforced by a variety of factors and events, including concerns about the risk of audit failures, the global expansion of the major audit firms and increased complexity of both accounting standards and financial instruments. In addition, the challenges associated with fair value estimation processes, which have been amplified by the current market crisis, have similarly underscored the importance of high quality audits.
The current market turmoil and demand for increased transparency suggests that reliable, clear financial information supported by quality audits are key elements in enhancing market confidence, according to the Committee. Thus, it says its continued involvement to promote audit quality is warranted.
Negative outlook for HFA sector
Moody's outlook for the state housing finance agency (HFA) sector is negative as it faces unprecedented challenges from the capital markets and a weakened real estate market. "Lower credit quality of counterparties, including financial institutions and mortgage insurers, further contributes to stress on HFA programmes," comments Moody's svp Florence Zeman.
Still, many state housing finance agencies entered the stressful market conditions with strong financial positions and should be able to withstand a certain amount of stress without affecting programme ratings. In addition to healthy finances, there are a number of positive credit factors that are likely to mitigate the market challenges that many of the HFAs are facing, the agency notes.
"Most HFAs are well positioned to handle these various pressures, due to strong asset quality of HFA portfolios and experienced management that may mitigate effect on programme ratings," says Zeman. "Many are managed by experienced teams who are actively responding to the challenges facing the industry."
She adds that the use of federal mortgage insurance and the securitisation of HFA loans into MBS issued by Ginnie Mae, Fannie Mae or Freddie Mac have mitigated the effects of the housing market downturn on HFA portfolio performance. "And, while counterparty risk has been highlighted by downgrades of financial institutions involved in HFA financings, counterparty diversification in many HFA portfolios should mitigate against the credit deterioration of a specific counterparty," notes Zeman.
But the pressures and conditions contributing to Moody's change in the sector outlook to negative are challenging and include increased interest costs on long-term bonds that have accompanied changes in the capital markets. Higher interest rates may pose difficulties for many HFAs to maintain the desired spread between bond costs and mortgage earnings.
"Volatile short-term markets and credit concerns about some liquidity providers have made variable rate debt more expensive, caused difficulties in remarketing and have - for the first time - resulted in material levels of bond purchases by liquidity banks," says Zeman.
Counterparty risk initiatives examined ...
A new report from Aite Group examines the different industry initiatives currently proposed concerning the clearing of CDS and the different aspects of counterparty risk under various types of contractual trading arrangements. The report also profiles a number of vendors that provide post-trade processing to the CDS market.
The existing bilateral trading arrangement for CDS has proven to be a contributor to systemic counterparty risk, Aite Group says. Without a central hub to assess real-time system-wide risk and manage collateral requirements, outstanding CDS contracts must currently be accounted for in a siloed fashion. With the credit crisis continuing, the Federal Reserve is looking to the private sector for clearing solutions to lower systemic risk in the CDS space.
CME/Citadel, ICE, NYSE Euronext and Eurex have responded to the call, and all hope to provide a counterparty clearing solution by way of an exchange model. NetDelta, on the other hand, is proposing a counterparty clearing solution that does not rely on mutualising risks. Whichever clearing solutions are adopted, they will work best for fungible, vanilla structures with widely followed underlying reference assets.
"In this rush for a solution to minimise systemic risk in the CDS space, market participants and regulators must be mindful of the different aspects of counterparty risk inherent in those solutions," says John Jay, senior analyst with Aite Group and author of the report. "The proposed solutions do not directly address legacy CDS positions and custom-made CDS structures. As such, with any trends toward standardised structures, dealer firms will need to weigh shrinking spreads against what they can make in more customised transactions."
... while WMBA clarifies clearing assumptions
The Wholesale Market Brokers' Association (WMBA) has released a statement that clarifies some assumptions regarding central counterparty clearing and emphasises that these benefits are also available in OTC markets.
"The OTC markets have traded, and need to continue to trade, separately from exchange markets for many reasons," explains WMBA chief executive Stewart Lloyd-Jones. "OTC markets are both larger in scale than exchange markets and may be customised to render them a flexible risk management tool. As such, their use benefits governments, corporations, investors and individuals worldwide."
He adds that an inaccurate distinction is often made between 'regulated' and 'unregulated' markets, with exchange markets often being presented as 'regulated' due to exchanges being mandated to regulate the content, behaviour and participation in specified products. The perception that all OTC markets are unregulated is incorrect; all major OTC financial market participants are individually regulated and supervised.
While the WMBA endorses the efforts of regulators to encourage the introduction of central counterparty clearing in OTC markets, it stresses that several OTC products - such as interest rate swaps and US Treasuries - are already fully compatible with the smooth operation of a CCP facility. For the purposes of counterparty risk, it is essential to note that in OTC markets the means of execution is not relevant as long as transactions are matched and confirmed electronically.
Asian CSOs impacted
S&P has lowered its ratings on 61 tranches relating to 53 Japanese synthetic CDO transactions and affirmed its rating on one deal, removing it from credit watch with negative implications. Among the 61 downgraded tranches, 23 tranches remain on watch negative and 38 tranches have been removed from credit watch. The actions reflect S&P's views on the impact of several events that have occurred since its previous rating actions on 30 October relating to the relevant portfolios, including rating migration, the credit event auctions for the Icelandic banks and revisions to its correlation assumptions.
At the same time, the agency downgraded the ratings on 68 tranches of Asia Pacific (ex-Japan) synthetic CDOs, with 21 tranches also being placed on watch negative the ratings on another two withdrawn. The SROC levels for the ratings that were placed on credit watch with negative implications fell below 100% at the current rating levels during the SROC analysis for November.
US$46.1bn of AIG's CDOs purchased
AIG reports that the financing entity recently created by the Federal Reserve Bank of New York (FRBNY), designed to mitigate AIG's liquidity issues in connection with its CDS and similar derivative instruments written on multi-sector CDOs, has been launched (see SCI Issue 112). To date, the new entity has entered into agreements with AIGFP's CDS counterparties to purchase approximately US$53.5bn principal amount of CDOs. US$46.1bn principal amount of such CDOs have been purchased and the associated notional amount of CDS transactions have been terminated in connection with such purchases.
AIG has provided US$5bn in equity funding and the FRBNY will provide up to approximately US$30bn in senior funding to the financing entity, of which approximately US$15.1bn has been funded to effect purchases of CDOs. The entity will collect cash flows from the assets it owns and pay a distribution to AIG for its equity interest once principal and interest owing to the FRBNY on the senior loan have been paid down in full. Upon payment in full of the FRBNY's senior loan and AIG's equity interest, all remaining amounts received by the entity will be paid 67% to the FRBNY and 33% to AIG.
Derivatives demand set to rise
Use of derivatives by fund managers will rise over the next 12 to 18 months despite market turbulence and record levels of redemptions from hedge funds, according to a new report from risk consulting company Protiviti Ltd. However, the report warns that changes need to be made to secure the operating environment for derivatives and ensure that UK firms maintain their competitive advantage.
According to a recent Protiviti survey, 79% of traditional fund managers, hedge fund managers and service providers expect their firm's use of derivatives to increase. As a consequence, most (84%) also plan to improve their derivative capabilities over the coming year.
The overwhelming driver behind companies considering making improvements to their derivatives capabilities is 'demand from the front office and competitive pressures' (68%), the survey shows. 'UCITS approval and the need for daily risk management' was the next most popular incentive to invest.
A minority of firms (16%) indicated that they are unlikely to invest in their derivatives capabilities, citing as their reasons cost and a view that derivatives will be less of a requirement for their firm going forward.
Although fund managers and the wider investment community are still pursuing derivatives, almost a third (31%) of those surveyed said that a lack of available skills and resources was the most significant risk they faced in managing derivatives in the future. 'Governance arrangements and the segregation of duties' was cited by 21% of those surveyed, with the remainder naming 'time constraints on daily processes', 'inaccurate data' and 'robustness of the control environment'.
According to Protiviti, a failure to provide a secure operating environment for derivatives could lead to a back-log of confirmations and settlements and consequent risk, compliance and fund reporting issues. The end result could be that clients would fail to award mandates or worse that mandates would begin to be taken away from fund managers who cannot demonstrate the robustness of their operations and risk management.
Rob Nieves, director, Protiviti comments: "We believe that the fund management industry has reached an inflection point in its use of derivatives and that they are here to stay as an asset class. While it's clear firms would like to improve their derivative capabilities, many are caught in a vicious cycle of being unable to free-up skilled staff who can then tackle more strategic issues like implementing new systems and getting better value from their outsource providers."
Troubled company index deteriorates again
Kamakura Corporation has revealed that its index of troubled public companies deteriorated again in November, representing the 15th decline in credit quality in the last 16 months. The Kamakura global index of troubled companies increased to 22.6% of the public company universe from 22% of the universe in October.
The all-time high in the index was 28%, recorded in September 2001. At the 22.6% level, the index shows that credit conditions are better than only 6.3% 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.
Fitch clarifies REIT/CREL assumptions
Fitch has clarified the correlation and recovery assumptions it will apply to real estate investment trust (REIT) debt and commercial real estate loans (CREL) backing CDOs. Following issuance of final criteria, the agency will conduct a review of its existing portfolio of CDOs referencing structured finance assets. Fitch has also placed additional ratings from 11 CDOs backed primarily by trust preferred securities (TruPS) issued by REITs on rating watch negative, reflecting the potential for ratings to be affected by the proposed changes.
The update recognises that REITs as a corporate industry, because of their common exposure to the real estate sector, are more correlated to CMBS and RMBS than other corporate industries. The update also clarifies the recovery rate assumptions for REIT debt, which are the same as for other corporate industries and depend on the security position of the debt.
CMBS delinquencies to see upward trend
CMBX analysts at Barclays Capital comment that a relative spike in delinquencies last month, led by the retail sector, marks the beginning of a sustained upward trend. "We have repeatedly stressed that CMBS delinquencies are a lagging indicator of credit performance and tend to lag changes in employment by close to a year. Eleven months after the unemployment rate started to rise, the average non-performing rate across CMBX 1-5 increased 14bp this month to 0.53%," they say, adding that CMBX.2 was the worst performing series and saw a spike to 1.07%, an increase of 39bp.
At the property level, while multifamily and office showed an increase in 60+ day delinquencies across all series, the largest increase occurred in retail. Retail weakness was concentrated in CMBX.2, where the largest three loans to go delinquent are secured by retail collateral. BarCap analysts point to multifamily weakness across CMBX.1, 3 and 4.
"November also provided evidence of the lumpy nature of CMBS collateral, which should lead to a choppy rise in delinquencies/defaults as compared to other securitised credit sectors. For example, the average increase in the non-performing rate across the 25 deals in CMBX.2 was 39bp, with just under half of this contributed from only one deal," they say.