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The eye of the storm

Financials battered as losses continue

Financial names included in the iTraxx/CDX indices suffered unprecedented widening over the last week amid a stream of negative headlines surrounding bank losses and downgrades, and monoline exposures. But the market is bracing itself for even more pain, as further losses are revealed.

"The ABX index is pricing in at least US$200bn of losses due to mortgage defaults, and banks and brokers are likely to experience around half of those losses," notes Chris Flanagan, head of global structured finance research at JP Morgan. "So far around US$30bn to US$40bn of these losses has been recognised in financial reports – leaving the remainder unaccounted for."

The remaining losses are expected to be borne out in super-senior CDO exposure – the space in which monolines and financials typically operate.

Indeed, Citi analysts estimate that appropriate super-senior write-downs (consistent with 13% mortgage pool losses) are around 30% in high grade deals and 60% on mezz deals done in 2006 and 2007, but of almost nothing on the older vintages. They calculate that, excluding Citi from their analysis, investment banks face around US$43.6bn in super-senior write-downs (with Merrill Lynch accounting for about US$10.2bn of them) – and that about a further US$20bn of losses from sub-prime loans will have to be absorbed.

RBS, UBS and Barclays Capital were among the names which have seen the largest moves within the iTraxx index, while the biggest CDX movers last week were MBIA and Washington Mutual. Radian and Countrywide spreads doubled in the month of October to 816bp and 458bp respectively.

One structured credit investor confirms that the widening has been driven by extreme protection buying via out-of-the-money index options, for example. "We've seen a lot of momentum trades from hedge funds involving shorting financial names. But buy-and-hold investors have also been shorting them – these names were extremely efficient and the double-A rating of many of them meant that they were appropriate for inclusion in synthetic CDOs," he says.

Amid the flurry of recent investment bank reporting, Citi admitted marking its US$43bn super-senior portfolio to model due to the lack of observable inputs and that it hadn't hedged its CDO risk, as well as that it had bought back US$25bn of CP which was the funding mechanism for some of its CDOs (see also job swaps).

"[Citi] will, of course, have secondary and tertiary exposure and also has significant counterparty exposure – watch this space, monoline exposure could be the 'next big thing' and we doubt whether many (any?) banks have a handle on this number," warn analysts at RBS.

Moody's and Fitch downgraded and left on rating watch negative Citi's rating, while S&P moved to watch negative – against a backdrop of plummeting share prices. The agencies highlighted the extra US$8bn to US$11bn of further write-downs expected (on top of the US$6.5bn already reported) from the bank, as well as the potential resulting capital strain in the near-term – particularly in light of its repeated assertion that the dividend payout won't be cut.

The investor says he is surprised that more banks haven't revealed their losses, given that their stocks are four to five points down anyway. "They might as well come out with some more bad news and come clean by year-end – US$100bn exposure between the top 20 banks is reasonable and can be absorbed. The more banks that start 2008 with a clean slate the better – otherwise rumours will continue to circulate. But I suppose it takes time for the banks themselves to understand their positions."

To add to the uncertainty swirling around the market, Fitch announced that it is reviewing its capital adequacy analysis for monoline insurers – which may result in one or more of the financial guarantors no longer meeting the capital requirements for a triple-A rating (see lead round-up story for more on this).

However, the RBS analysts point out that the chance of a monoline insurer defaulting is remote. They aren't required to post collateral in the event of downgrades or mark-to-market movements; they typically have significant control over the timing of payments for principal under their guarantees; and the insurance contracts are not typically cancellable on a downgrade of the monoline – meaning that future revenues are unlikely to disappear even if new business does.

Estimates for losses to be taken in Q4 are nevertheless beginning to surface, with market rumours suggesting hits of US$8.5bn for UBS and US$3bn for Morgan Stanley. Brokers are likely to come under increasing pressure to revisit all their exposures and further admissions are expected to emerge in the coming weeks.

CS

Permira debuts

Flexible structure for first-time manager

RBS is in the market with the €290m PDM CLO I transaction. The deal comes at an interesting time, given that it will be managed by debutants Permira Debt Managers (PDM).

The transaction comprises €208.5m triple-A rated Class A notes, €11.25m double-A Class Bs, €17.25m single-A Class Cs, €16.5m triple-B minus Class Ds, €13.5m double-B minus Class Es and €33m unrated Class F notes. Provisional ratings have been assigned by Moody's and S&P.

One source suggests that the transaction may not be a pure arbitrage CLO (given the first-time nature of the manager and the current environment), while another speculates that it might represent an exercise in warehouse risk management by RBS (given the manager is a private equity firm). Neither the arranger nor the manager returned calls, but analysts at S&P confirmed that a portion of the equity had been retained by PDM and that the agency was mandated for the deal in the summer.

PDM is expected to purchase at least 90% of the target par amount by closing and there is a six-month ramp up. After the seven-year reinvestment period, new assets can only be purchased if they have an equal or better rating than those sold and an equal or shorter maturity date.

The €300m portfolio will primarily comprise senior secured, senior unsecured and mezzanine loans, and high-yield debt. It is expected to be diversified across 13 countries and 24 industries.

There is a 20% short bucket, whereby the manager can enter into naked and off-setting short CDS positions, in some cases by using principal proceeds. Before entering into such an obligation, the coverage tests and weighted-average spread tests must be satisfied. Short CDS will be deemed to be offsetting only if the terms of the trades are identical and the counterparties are the same.

One of a range of combinations of minimum spread and PIK interest, weighted-average recovery rates and breakeven default rate criteria set out in the rating agency matrices can be chosen. The objective of the test matrix is to offer the manager greater flexibility in managing the portfolio, while maintaining compliance with the various collateral quality tests.

The manager may use some of its senior fee to satisfy the weighted-average spread test. However, the minimum spread left to be paid to the rated notes will be effectively the same whether or not the manager defers the senior fee.

When the senior investment management fee is reduced and deferred to the next payment date, the deferred fee will be paid subordinate to the rated notes and no accrued interest will be paid. The reduction of the senior investment management fee will be subject to a minimum of 15bp on any payment date.

The S&P analysts note that this feature gives some additional comfort if the manager is substituted, since the transaction can generate a senior fee for the new manager. The manager may only reinstate the amount of the senior fee, previously paid as additional subordinated fee, if the minimum weighted-average spread test is satisfied.

Following the end of a four-year non-call period, the notes may be fully redeemed in order of priority at the option of the Class F noteholders. The notes may also be fully redeemed at the option of the Class F noteholders or the controlling class on any payment date if certain tax events occur relating to the collateral.

In addition, an optional redemption of the notes in part can be initiated at the manager's discretion if, during the reinvestment period, it cannot source assets that meet the portfolio guidelines and the reinvestment criteria. The rated notes would be redeemed at their principal amount outstanding, plus accrued interest, to the date of redemption.

CS

Strong performance

Spanish SME CLO relative value revealed

A new study shows that the performance of Spanish SME CLOs continues to be exceptional, with few collateral defaults and low delinquencies. The A3 and A1 tranches of the IM Grupo Banco Popular FTPYME I and II transactions, as well as the A3 tranche of Bancaja 5 are top picks in terms of offering relative value.

These bonds price relatively wide for a short WAL and their collateral pools contain a large proportion of mortgage-secured assets, according to research conducted by analysts at Barclays Capital. The A2 and A1 tranches of the BBVA 4 and 5 deals, together with the A2 tranche of Santander Empresas 1 were judged to offer relative value on the basis of spread and WAL.

The coverage includes 33 transactions from the six largest originators of Spanish SME CLOs, which together account for over 70% of issuance and 75% of notes outstanding in the sector. Secondary pricing (as of 25 October) from Markit was available for a significant number of these bonds at the triple-A level, but not for lower-rated tranches. The analysis was therefore restricted to triple-As and how they price compared with different collateral characteristics.

The average number of loans in the deals included in the analysis is well above 3,000, with large variations between originators. In most transactions, the largest obligor accounts for less than 1% of the portfolio and the largest 10 obligors account for less than 8%. Most of the borrowers in the pools aren't rated; however, Moody's mapped originators' internal credit scores with its ratings and has estimated that the average quality of the SMEs would correspond to a Ba rating.

Similar to other sectors, SME portfolio composition has evolved, with a tendency for somewhat more lenient criteria for inclusion in the pools. While certain programmes have maintained a similar mix of collateral from one deal to the next, overall the analysts discern a slight deterioration in collateral quality.

"We are still highly comfortable with the sector as a whole, but more recent deals have suffered from a slight deterioration in collateral quality, visible in higher industry concentrations, lower proportions of loans backed by mortgages and an increase in LTVs for the pool portions backed by mortgages," notes Barclays Capital research analyst Anca Badea.

Over the past year, concerns about oversupply – especially in coastal areas, such as Valencia and Catalunya – have emerged, and house price growth has started to soften. Within the universe covered in the Barclays Capital study, exposure to real estate and construction activities ranges between 20% and 50% (although there is no exposure to real estate developers).

The performance of Spanish SME CLOs nevertheless continues to be extremely good – among the best in Europe, compared with the other jurisdictions in which this type of transaction is common. Defaults are well below the base case rating agency expectations, running at around 0.13%. Although they have been rising on average, the increase was very modest and the scale of the losses is negligible.

"With the Spanish economy under pressure, we may see the number of defaults rise slightly. However, given their current levels, we expect the up-tick to be negligible and the deals to remain comfortably within the rating agencies' base case expectations," says Badea.

2007 year-to-date public Spanish SME CLO issuance amounts to €9.4bn from six transactions. This figure does not include transactions launched after the liquidity crunch hit, which have been retained by originators on their balance sheet to be used as repo collateral with the central bank – such as the €2bn Empresas Banesto I and the €3.5bn Santander Empresas 4 deals. If these transactions – which are likely to have been publicly marketed under normal circumstances – are included, year-to-date issuance would total €19bn (already above 2006 issuance).

CS

Measure for measure

Coordinated regulatory response to credit crunch underway

Reports that Citi is undergoing a US SEC investigation into its accounting practices has sparked concern that regulatory bodies may begin adopting a heavy-handed approach to the structured credit sector. However, while some aspects of the market continue to be under scrutiny, most observers agree that the authorities are acting in a measured and methodological manner.

Some commentators believe that the market should be left to sort its own problems out – but this is unrealistic, according to Angus Duncan, partner at Cadwalader Wickersham & Taft. "We've seen central banks stepping in to help via liquidity injections, so I don't think that regulatory involvement is necessarily a negative move – as long as the authorities' actions help to calm the market so it can get back to some semblance of normality."

He adds: "There is a feeling that regulators are unlikely to let a major bank default, and so will put in place measures to ensure that this does not happen. But they've also learnt from the Sarbanes-Oxley experience that overregulation can lead to business disappearing."

In any case, it is doubtful whether a more highly-regulated market could have prevented the credit crunch from happening. "It was well known in the market that high levels of exposure to sub-prime assets existed – although, in hindsight, banks could have had better controls in place. Ultimately, it's up to shareholders to push for better risk management procedures at banks," says Duncan.

Events over the summer have certainly raised questions among the regulatory community, agrees Diane Hilleard, director of London Investment Banking Association. "We take comfort that the authorities are taking time to consider the issues properly before taking action," she comments. "There are parallel industry initiatives in train and it is important that market solutions are allowed to develop before regulatory intervention is considered. This analysis takes time. We also note the importance of international coordination and cooperation among regulatory bodies in considering these issues."

Rick Watson, head of the European Securitisation Forum (a SIFMA affiliate), confirms regulatory authorities accept that most issues can be solved by the market. "They're looking to be supportive of the market – for example, by rooting out any artificial stamping down of demand – to ensure that it is functioning properly. They are looking to identify ways that investors can receive all the information they require."

The ESF is currently reaching out to regulators to coordinate the information that they need from the different industry associations and security firms, and expects any findings to be released in March or April. The associations are also focussing on issues which could benefit investors, such as loan-by-loan disclosure – possibly involving changes to the data protection directive.

Meanwhile, it has been suggested that bringing forward the full adoption of Basel II may stimulate securitisation investment, but there is a question mark over how many banks would be caught by the resulting capital floors. Its implementation in January continues to be a priority: because it is a risk-sensitive regime, it is expected to have a positive impact on the investment environment.

Additionally, the new rules will spur transparency in the market – Annex 12 of the BIS framework includes a requirement for banks to report the aggregate amount of securitisation exposures they hold, broken down by exposure type, as well as the capital requirements arising from these exposures. Disclosures include those exposures that arise from securities retained or purchased, as well as those related to liquidity facilities and credit enhancements provided to ABCP programmes and SIVs.

For banks on the IRB approach, mandated disclosures include both a geographic and an industry breakdown of credit risk exposures, as well as a breakdown of exposures into bands of different probability of default, estimates of loss given defaults by portfolio and average exposure at default on any undrawn credit exposures.

One area that continues to be the subject of ongoing discussion, however, is liquidity risk management. Although the EU and the Basel Committee have been debating the issue for a while, the credit crunch has brought it into sharp focus.

CS

Citi...

The latest company and people moves

Citi...
Last Sunday, 4 November, Citi formally announced what had been anticipated for some days – significant declines since 30 September 2007 in the fair value of its US$55bn of US sub-prime related direct exposures and that chairman and ceo Chuck Prince was to leave the firm (see also this week's lead news story). Robert Rubin will now serve as chairman and Sir Win Bischoff will act as ceo while a full time replacement is sought for the bank, whose exposures could equate to a US$7.5-8bn hit, according to analyst estimates.

In Citi's announcement the bank said its sub-prime direct exposure as of 30 September consisted of approximately US$11.7bn of sub-prime related exposures in its lending and structuring business, and approximately US$43bn of exposures in super-senior tranches of ABS CDOs. The banks is understood to have established a dedicated team to focus solely on managing these assets and their resultant exposures – the sub-prime portfolio group. The team will be led by Rick Stuckey head of finance, G10 risk treasury and relative value, and assisted by Mark Tsesarsky, head of special situations securitisation in fixed income, as well as other expertise from Citi's various structured credit, securitised markets and independent risk management groups.

The US$11.7bn of sub-prime related exposures includes approximately US$2.7bn of CDO warehouse inventory and unsold tranches of ABS CDOs, approximately US$4.2bn of actively managed sub-prime loans purchased for resale or securitisation at a discount to par primarily in the last six months, and approximately US$4.8bn of financing transactions with customers secured by sub-prime collateral.

Citi's US$43bn in ABS CDO super-senior exposures as of 30 September is backed primarily by sub-prime RMBS collateral. These exposures include approximately US$25bn in commercial paper principally secured by super-senior tranches of high grade ABS CDOs and about US$18bn of super-senior tranches of ABS CDOs, consisting of around US$10bn of high grade ABS CDOs, US$8bn of mezzanine ABS CDOs and US$0.2bn of ABS CDO-squared transactions.

Citi...
Citi Alternative Investments has agreed to acquire Carlton Hill Global Capital, a specialised money manager in the global corporate credit markets focusing on credit derivative portfolio management. Carlton Hill will be formed as a new investment centre called Citi Credit Strategies (CCS) and will fall under the Citi Global Fixed Income (CGFI) group.

The group will be led by Carlton Hill co-founders James O'Brien and Jonathan Dorfman, who have been named mds. In addition, both have been named co-heads of the CGFI business, which includes several fixed income-related entities: Leveraged Loan Investments, Citi Municipal Investors, Citi Fixed Income Alternatives, CSO Partners, EMSO Partners and the Asia credit team.

Prior to co-founding Carlton Hill, O'Brien and Dorfman created, built and managed the global credit derivatives and structured credit business at Morgan Stanley

...Bang bang?
Michael Raynes, head of structured credit, and Nestor Dominguez, co-head of CDOs, have left Citi. Both were mds based in New York.

Credit fund discontinued
Primus Guaranty has decided to discontinue its Harrier Credit Strategies Fund's operations and expects to unwind its remaining positions following Harrier's trading losses in Q3. The company intends to reallocate approximately US$65m of capital it has invested in the fund to support the continued growth of its credit protection business. Primus expects to take a charge in the range of US$2-3m in the fourth quarter in connection with severance and capitalised software costs related to the fund's discontinuation.

Harrier trading losses, excluding interest income on its cash, cash equivalents and investments, were US$6.5m for Q307. "Harrier's third quarter 2007 results primarily reflect losses in our credit arbitrage trading activity, which had been negatively impacted by the illiquidity in these markets. All components of Harrier revenues are included in our economic results," Primus says.

Lewtan and S&P team up
S&P has announced it will make its credit ratings and credit market information available to subscribers of Lewtan's ABSNet platform. The move underscores the growing industry demand for credit ratings information, the two firms say.

Lewtan Technologies offering will include S&P current rating actions and presale reports to help support decision-making for financial professionals who issue, buy, sell or invest in asset-backed securities, as well as those who facilitate and support these transactions. Additionally, ABSNet users will be able to access S&P insight into deal-specific transactions, opinions on key risk and performance factors, commentaries on credit market developments, and outlooks and reviews of global rating trends.

MP

Updated approach for wrapped SF CDOs

A round up of this week's structured credit news

Updated approach for wrapped SF CDOs
Fitch Ratings proposes to update its analysis of SF CDOs insured by the financial guaranty industry and outline the potential implications for their triple-A insurer financial strength (IFS) ratings. The move marks an extension of an analysis completed on 6 September published in a special report entitled 'FinancialGuarantors - Matrix Hypothetical Sub-prime Stress Test Results'.

In this earlier report, Fitch discussed its 'stress test' analysis of the capital adequacy ratios of the financial guarantors based on potential credit deterioration in insured transactions with exposure to the sub-prime mortgage markets. The agency is updating its capital adequacy analysis due to the nature of recent rating actions taken by Fitch, S&P and Moody's with respect to SF CDOs exposed to sub-prime RMBS.

Generally, the extent of both downgrades and placements of securities on rating watch negative is broader and deeper than the assumptions used in Fitch's previous analysis. The new approach will focus on the nature of the SF CDOs held by each financial guarantor, with a goal of determining the likely ratings migration within each financial guarantors' SF CDO portfolio.

Lower ratings on insured transactions will result in higher capital requirements in Fitch's Matrix capital model, since simulated default rates increase when moving down the ratings scale. The agency notes that capital requirements in Matrix become especially pronounced for SF CDOs that are rated triple-B and lower, and it is expected that the ratings on some SF CDOs will migrate to these levels.

Fitch will also apply additional stresses to simulated recovery rates to SF CDOs as part of its capital adequacy analysis, which will increase simulated loss given default rates for this asset class. As the agency assesses the SF CDO portfolios of each financial guarantor, differentiation will be made based on the relative exposure to mezzanine and CDO-squared securities, as opposed to high grade CDOs.

Fitch will also focus on the attachment points on the insured securities. Mezzanine CDOs in this context are defined as those CDOs for which the ratings on underlying collateral are rated triple-B and lower. It is these mezzanine CDO securities for which ratings migration risk is generally the greatest, and loss severity in the event of default may be most pronounced.

Fitch's analysis of attachment points recognises that a vast majority of financial guarantor-insured SF CDOs were originally rated triple-A, but that in many cases the securities attached at levels well above minimum triple-A thresholds (super-senior attachments). Generally, the greater the attachment point in excess of a minimum triple-A standard, the more muted is the risk of material ratings migration or increased loss severity.

A possible conclusion of this analysis will be that one or more of the financial guarantors may no longer meet Fitch's triple-A capital guidelines. At the conclusion of its analysis, Fitch would expect to place on rating watch negative the IFS rating of any financial guarantor whose capital ratio falls below this triple-A benchmark, as at that point uncertainty would reach a materiality that would call into question the company's ability to maintain its rating.

Fitch would then expect to provide the company approximately one month to either raise capital or execute a risk mitigation strategy that would allow it to again meet the triple-A capital standards. Failure to do so would result in a downgrade of the IFS rating.

Should a financial guarantor add to its capital or engage in an effective risk mitigation strategy prior to the completion of its capital analysis, Fitch will consider the impact of such activities in formulating the conclusions from its capital analysis. Fitch expects to complete its capital analysis within the next four to six weeks.

The following are preliminary observations on the positioning of the triple-A rated financial guarantors and the relative probability that each may experience erosion of their capital cushions under Fitch's updated stress analysis:

- High probability: CIFG Guaranty (CIFG) and Financial Guaranty Insurance Company (FGIC) appear most likely to experience contraction in their capital cushions under Fitch's analysis, barring additional capital raising or risk mitigation efforts. This reflects the materiality of SF CDO exposures relative to the most recently measured capital cushion. Fitch notes FGIC appears to be the better positioned of the two, due to more recent improvements to its existing capital cushion;
- Moderate probability: Ambac Assurance Corp and Security Capital Assurance (SCA) may also experience pressure in their capital cushions due to relatively high SF CDO exposures relative to the most recently measured capital cushion. However, the degree of cushion relative to exposures is better than for the companies noted above. Fitch's assessment of SCA includes the impact of certain recent risk mitigation initiatives;
- Low probability: MBIA Insurance Corp appears to be materially better positioned than the four previously noted guarantors due a lower level of higher-risk SF CDOs relative to the most recently measured capital cushion. Fitch notes MBIA underwrote SF CDOs in Q307, and will consider these recently added exposures in its analysis;
- Minimal probability: Due to minimal SF CDO exposures and strong initial capital cushions, Fitch anticipates no capital or rating issues resulting from its updated capital reviews of Assured Guaranty and Financial Security Assurance.

Fitch recognises that financial guarantors view maintenance of their triple-A ratings as a core part of their business strategies, and management teams will take any reasonable actions to avoid a downgrade. However, the agency also recognises that recent capital markets volatility, including sharp declines in the share prices of the publicly traded financial guarantors, may make capital raising efforts difficult unless market conditions improve.

Fitch has previously stated that losses reported during Q307 by a number of financial guarantors due to mark-to-market accounting standards for insurance sold in credit derivative form are not a ratings concern. Similarly, Fitch's capital adequacy analysis will focus on underlying fundamental credit performance of insured portfolios, and will not be based on market value movements of insured securities.

Short total return indices for iTraxx
International Index Company (IIC) has launched European iTraxx Short Total Return Indices, designed to measure the performance of holding the respective on-the-run iTraxx CDS contracts. The indices start trading with five-year maturities and have the same composition as the existing iTraxx CDS indices.

The new iTraxx Short Total Return Indices comprise: the iTraxx Europe five-year short total return index; iTraxx HiVol five-year short total return index; and iTraxx Crossover five-year short total return index. "We are happy to offer this new total return performance measure within our global family of indices," comments David Mark, ceo of IIC. "The indices will enable investors to evaluate the investment performance of short credit products from an independent source. iTraxx Short Total Return Indices are another important step in expanding the iTraxx benchmark family of indices."

iTraxx Short Total Return Indices reflect a short credit position – i.e. buying credit protection through iTraxx credit default swaps – while simultaneously investing in money market instruments. The indices invest in the on-the-run iTraxx series that they track.

Markit will act as calculation agent for the new indices, while IIC has licensed Deutsche Bank to offer exchange-traded funds (ETFs) on them.

The launch of these three UCITS III funds will allow European clients to buy credit protection in an ETF format for the first time. It is expected that the iTraxx ETFs will be popular with corporates, insurance companies and asset managers looking for protection from market turbulence in a non-derivative format. The ETFs will be available for purchase OTC and will be listed on the Italian stock exchange by the end of the month.

Marco Montanari, head of fixed income ETF-structuring at Deutsche Bank, says: "These new ETFs confirm Deutsche Bank's innovation capabilities. We are reacting quickly to developing trends to bring new products to market as quickly and efficiently as possible. These ETFs offer clients exposure to new exciting indices in a timely manner."

Deutsche Bank launched its ETF platform, db x-trackers, this year and has already reached more than €4bn assets under management across more than 50 equity and fixed income ETFs – including the EONIA ETF, the most successful European ETF in 2007.

Moody's reports on EODs
As highlighted in last week's issue, recent downgrades of sub-prime RMBS have triggered overcollateralisation-linked events of default (EODs) in several cash and hybrid CDOs, giving senior investors the right to potentially liquidate the underlying asset pool. Moody's says in a new report that it is closely monitoring the senior OC values of CDOs where the downgrades may affect the calculation of the aggregate outstanding par amount, and is taking action as appropriate.

Many transactions with EODs based on OC ratios include rating-based haircuts when calculating the aggregate outstanding par amount of the underlying assets. Recent downgrades of sub-prime RMBS have magnified the impact of rating-based par haircuts on OC-linked EOD triggers, causing several CDOs to breach this provision.

Upon receipt of the notice of default, Moody's is identifying the noteholders' options as detailed in the transaction documents and assessing the likely rating impact.

As part of its monitoring process, Moody's may contact the trustee, underwriter, collateral manager and, to the extent possible, the senior investors representing the controlling class of the relevant CDO.

Fitch to review CDO methodology
As discussed in last week's issue, Fitch is in the process of reviewing its rating methodology and model assumptions for all new issue CDO ratings. For CDOs collateralised by structured finance securities, the review includes a reassessment of sub-prime vintage performance and associated loss severity and correlation.

Additionally and more broadly, the agency has announced that it is reviewing its core VECTOR modeling assumptions and methodology which could impact ratings of all CDOs, including those with corporate bond or corporate loan collateral. Key review factors include default probability, ratings migration, credit concentrations and recovery assumptions.

Fitch will complete ratings on new issue CDO transactions that price between now and 15 November, but investors should be aware that the agency is reassessing its analytic views – which could impact existing ratings. Fitch will not publish new ratings after 15 November on any CDOs that could be impacted by the changes, until the reassessment of the methodology is complete. The review is expected to be completed in four weeks.

Further details on M-LEC
Further details are beginning to emerge about the proposed super-SIV, despite reports that it may be floundering. According to market sources, none of the assets purchased by M-LEC would be 90 days or more past due, in default or externally rated below investment grade.

The structure involves banks providing loan funding facilities (whereby they extend a term loan to the vehicle) or securities funding facilities (a commitment to purchase short-term notes or enter into a securities borrowing transaction). The vehicle will draw upon all liquidity facilities on a pro-rata basis.

In order for assets to be sold to M-LEC, it is believed that 75% of CP holders in each SIV need to give their consent. Investors will then be entitled to 94% of the value of the assets they sell in cash, or 89% cash and 5% in senior capital notes.

Junior capital notes are also likely to be on offer based on a formula set by M-LEC, where investors would get 3% plus half the discount at which they sell their assets. A management fee of 1% is expected if the assets sold are under US$5bn and up to 1.5% if the assets are over US$15bn.

Historical lows for CRE CDO delinquency rates
Delinquency rates on US commercial real estate loan (CREL) CDOs are at historical lows, mirroring US CMBS – though there may be more volatility in the coming months, according to Derivative Fitch's inaugural monthly US CREL CDO loan delinquency index.

The agency currently rates 35 CREL CDOs encompassing nearly 1,100 loans with a balance of US$23.5bn. "With a smaller universe, more transitional collateral and higher leverage than CMBS, Derivative Fitch expects more volatility in the monthly CREL CDO delinquency rate compared to CMBS," says Fitch senior director Karen Trebach.

When considering repurchased loans, the October 2007 US CREL CDO loan delinquency rate of 0.36% is higher than the US CMBS delinquency rate of 0.29% for September 2007, but both are at historical lows on an absolute basis. Excluding repurchased loans, the US CREL CDO loan delinquency rate is 0.08% for October 2007. Loan delinquencies consist of loans that are 60 days or greater delinquent, including performing matured balloons.

Eight loans were delinquent or repurchased in the October 2007 report. By balance, 98% can be classified into three categories: hotel loans whose business plans have not been actualised (41.8%); land loans whose collateral value has declined (32.9%); and condo conversion loans that did not meet sales velocity expectations (23.2%).

Over 80% of the delinquent and repurchased loans were whole loans as opposed to subordinate debt. As Fitch expected, whole loans on transitional assets exhibit higher volatility than B-notes or mezzanine loans on stable assets, leading to a greater probability of default. The loss severity for whole loans, however, will be lower than B-note or mezzanine loans.

Over 85% of the delinquent and repurchased loans were from the 2006 vintage. Due to the short-term nature of the collateral in CREL CDOs, many loans in the 2006 vintage have already reached maturity and some are facing balloon defaults.

Fitch considers credit impaired assets that have been removed from the pool to be part of the delinquency rate. Excluding these repurchased loans would overstate the performance of a pool.

To date, most CREL CDO asset managers have opted to buy out credit impaired assets at par rather than workout the loan within the CDO. This month, asset managers reported that five assets were repurchased, representing 0.28% of all collateral.

Fitch also reviewed loans that were 30 days delinquent. Although this delinquency category is generally considered volatile with loans moving into and out of the category, it can be an early warning sign that a loan could ultimately have a loss.

Three loans, representing 0.13% of the CREL CDO collateral, were 30 days delinquent in October 2007. One loan, representing two-thirds of the total 30-day delinquency, is a chronic late payer that is not currently anticipated to result in a loss to the CDO.

In its ongoing surveillance process, Fitch will increase the probability of default to 100% for delinquent loans that are unlikely to return to current. This adjustment could increase the loan's expected loss in the cases where the probability of default was not already 100%.

The weighted average expected loss on all loans (PEL) is the credit metric used to monitor the performance of a CREL CDO. Issuers covenant not to exceed a certain PEL and Fitch determines the ratings of the CDO liabilities based on this covenant.

Fitch analysts monitor the as-is PEL over the life of the CDO. The difference between the PEL covenant and the as-is PEL represents the transaction's cushion for reinvestment and negative credit migration.

CRE CDO issuance to decline
The liquidity crunch will cause CMBS and CRE CDO issuance to decline over the next few quarters at least, says Moody's in a new report. As predicted in SCI issue 60, the liquidity crunch is reducing collateral origination to a trickle and prompting issuers to revisit simpler and less risky loan and deal structures.

Moody's says aggressive loan underwriting and peaking property values will also result in increased delinquencies in the near future. The two most significant metrics for tracking commercial loan strength, Moody's debt service coverage ratio (DSCR) and loan to value (LTV) ratio, were weaker in Q307.

The DSCR, which provides an indication of term default risk, reached a new low of 1.22 for 3Q07 – roughly half the level of the third-quarter just two years earlier. This illustrates a meaningful pickup in term default risk, which Moody's addressed by increasing subordination requirements.

Overall LTV ratios, which are an indicator of balloon risk, reached a new high of 117.5 for 3Q07 conduit deals, as measured on a Moody's stabilised cap rate basis. The current level may represent the peak for the near term as the better underwritten loans, which have yet to be securitised in meaningful numbers, make up a larger share of future deals, says Moody's.

"Loan underwriting has become more conservative, but issuers are still clearing out a large backlog of more aggressively underwritten loans," says Moody's md Tad Philipp, author of the report.

The agency says the market correction for commercial property should not be as sharp as that for sub-prime RMBS, citing transparent cashflows, sophisticated investors and strong property fundamentals.

Moody's also expects the liquidity crunch to dampen CRE CDO issuance, even though these structures did not fall prey to the same aggressive underwriting as CMBS deals. "Although, CRE CDOs have always had appropriate and differentiated subordination levels, we expect the market to demand simpler deals in the future," explains Philipp.

CRE CDOs could simplify their structures in the future by utilising smaller reinvestment buckets, fewer pro-rata pay structures, and less IC/OC tests. They may also simplify collateral by making less use of B-notes and more whole loans, fewer repositioning stories and more stabilised assets, according to Moody's.

Risk hedging for Japanese institutions
Moody's says that balance-sheet synthetic CDOs are likely to play an increasingly important role as a risk hedging tool in the context of financial institutions' credit portfolio management CPM strategies. Japanese banks are increasingly actively structuring balance-sheet CDO transactions (see SCI issue 59): between July and September 2007, Moody's rated four such transactions – nine altogether since the beginning of 2006.

These high-volume balance-sheet CDOs by the megabanks are seemingly driven by CPM strategies focused on risk-hedging (including credit concentration risk) in their portfolios. Moody's report provides an overview of Japanese financial institutions' CPM activities and the balance-sheet CDO market in Japan. It also summarises the agency's rating approach to balance-sheet CDOs in the country.

Corrective phase for leveraged finance
The long bull-run in global leveraged finance came to an abrupt halt in June 2007 as the dislocation in the sub-prime mortgage sector spilt over into other asset classes. The market has now entered into a corrective phase, following a long upswing in the risk profile of new business – which was reflected in higher leverage ratios, the erosion of risk-based pricing and the introduction of loans with reduced covenant protection, according to S&P.

"The speed of the market downturn has left the banking industry with about US$350bn of funded and unfunded commitments, and led to sizable markdowns in third-quarter earnings," says S&P credit analyst Richard Barnes.

The agency believes, although not without some reservations, that leveraged finance arrangers will be able to work through the debt overhang without further material markdowns. This view is based on three key factors:

- Liquidity has gradually returned to the leveraged finance market since September, particularly in the US, and has led to a steady improvement in syndication activity and secondary market pricing. The European market has been slower to recover, but the backlog is now starting to move.
- A sizable proportion of current commitments was underwritten in the third quarter, when transaction structures and pricing were becoming less aggressive. On top of sales and syndications of leveraged debt, banks' exposures to pre-June commitments are reducing as certain transactions are cancelled, and others are restructured or repriced.
- Since investor sentiment still appears somewhat fragile, the agency is alert to the risk that the improvement in the leveraged finance market might run out of steam, but it doesn't see this as the most likely scenario. Since the borrowers have speculative-grade ratings, this sector is more vulnerable than others to negative economic news. The speculative-grade corporate default rate remains at a very low level, but S&P believes it is now likely to rise toward the long-run average, although a sharp increase isn't expected.

"In addition to its risk implications, the turn in the leveraged finance cycle also has significant consequences for arrangers' revenue prospects. New business origination has experienced a significant decline since June, and we do not expect to see material new transactions until mid-2008 at the earliest," adds Barnes. This is likely to lead to bonus and staffing cuts as banks adjust their cost bases to the new environment.

Ultimately, the demise of aggressive structures, such as covenant-lite loans payment-in-kind bonds and equity bridges is a positive development for the banking industry, as they represent – in S&P's opinion – the excesses of the bull market.

Fitch reports on TruPS CDOs
Following a review of CDOs backed all or in part by trust preferred securities (TruPS) and subordinated debt issued by REITs and homebuilders, Derivative Fitch has published a special report summarising the rating actions, as well as various collateral characteristics of the underlying CDO portfolios.

Last month, Fitch affirmed US$10.2bn of rated liabilities and downgraded US$1.2bn (7.7% of rated liabilities in this sector), affecting CDO liability ratings in the single-A to double-B range. Primary drivers of the downgrades were the default of underlying issuers of TruPS, as well as material negative rating migration with respect to large portions of the remaining collateral portfolios.

Fitch also discusses in the report its outlooks on the primary sectors represented in the underlying portfolios, namely REITs, homebuilders, banks and insurance companies.

Coupons fixed for additional XO maturities
International Index Company has set the coupons for the additional iTraxx Crossover Series 8 indices which began trading yesterday, 6 November. They are 270bp for the three-year maturity and 390bp for the seven-year maturity.

Carador reports
In its latest company report, Washington Square Investment Management's permanent capital vehicle registered an un-audited net asset value per share of €0.8317 as at the close of business on 30 September. Carador's NAV decreased by 5.4% in September – although by adjusting for the payment of the dividend in the month of 6.9 cents per share, the NAV increased by 2.4%.

This month's calculations include an estimated €619,960.77 worth of net cash flow interest received in the month (to be allocated between capital and income), which equates to €0.012 per share.

The Manager referred 13 investments to the pricing committee which it considered were incorrectly priced by market counterparties for the end-September net asset value calculation. The pricing committee proposed that, for these 13 investments, the valuation obtained using Washington Square's internal models – adjusted for the price provided by market counterparties – should be the preferred alternative to the market counterparty valuation. This proposal was accepted by the board on 2 November.

During the period, Carador sold one investment. The company purchased US$2m notional of ACA ABS 2006-02 on 29 November 2006 at a price of 77% of its nominal value and liquidated the position on 23 May 2007 at a price of 30% of its nominal value. During the holding period, the company received US$32,104 worth of interest.

According to the report: "We are starting to witness differentiation between CLOs and other CDOs backed by real estate assets. We have seen increasing demand for tranches of triple-B and double-B rated CLOs, as well as equity tranches from existing and new investors."

The manager continues to be cautious on new CLOs. "There are opportunities, but each transaction has to be analysed in detail as we also believe that the assumptions used by the market in terms of loan refinancing rates, future spread levels, etc are far too optimistic. We have seen limited activity in the secondary market, although we have been involved in bidding for several secondary positions and have found strong competition, and a clear lack of severely distressed levels."

European SME CLOs stable
Fitch says that European SME CLO performance has been largely stable in the year-to-date, as indicated by rating actions taken during the period. In view of the recent events in the credit market, the agency's SME tracker provides a timely indication of European SME CLOs performance trends.

While the issuance volumes are as of 30 September 2007, the performance trends by transaction type are as of the end of June 2007 for comparison purposes. The data for each transaction are as of the latest report date, indicated on the relevant transaction sheet.

From the beginning of the year to 31 October 2007, there had been a downgrade of one tranche, affirmations of 162 tranches and upgrades of three tranches. One tranche that was placed on rating watch negative was resolved with an affirmation. In light of on-going credit market events and expected economic growth adjustments in some markets, the agency continues to monitor the transactions closely and specific statements relating to various specific deals and sectors will follow as appropriate.

The Spanish segment has been one of the star performers among European SME CLOs. However, credit market events and a potential downward adjustment in the medium-term economic growth are causes for concern (see separate news story on Spanish SME CLOs).

Many underlying loans are floating-rate and will be affected by the upward pressure of interest rates. A high concentration of a region where housing supply outpaces demand, or real estate or construction sectors, in a portfolio is likely to be detrimental to the performance of that transaction going forward.

CS

Trading ideas: apart at Home

Dave Klein, research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on KB Home

Credit and equity risk are unambiguously linked, as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with liquid instruments, such as credit default swaps (CDS) and equity puts. In this trade, we analyse hedging CDS directly with equity.

The trade exploits an empirical relationship between CDS and equity, and an expectation that equity drops precipitously in the case of default. For certain names, the payout from buying CDS protection and buying equity behaves like a straddle.

If equity sells-off, we expect CDS to sell-off more in dollar terms. If CDS rallies, we expect equity to rally more (again in dollar terms). This is also the basis for the so-called "wings" trade, where CDS is financed using equity dividends.

For this trade, we choose our hedging ratios based on a fair-value model that incorporates equity price in distress (near default) situations. Given the straddle-like payout, we are going long volatility and taking advantage of a non-linear relationship between CDS and equity. The trade on KB Home (KBH) takes advantage of this relationship by buying equity shares and buying CDS protection.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices and equity-implied volatilities to credit market spreads. There are a number of ways to accomplish this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets. We refer the reader to a CDR Trading Technique article – Capital Structure Arbitrage – for more detail.

The first step when screening names for potential trades is to look at where equity and credit spreads stand in comparison to their historic levels. Exhibit 1 shows the past year's levels for KBH's equity (inverted) and CDS spreads. Recently, KBH's CDS has outperformed its equity and this trade is, partially, a bet on a return to fair value.

Exhibit 1

Comparing market levels over time gives a rough feeling for how each security moves in relation to the other. In order to judge actual richness or cheapness, we rely on a fair value model.

Given that our trade is a combination of CDS and equity, we consider the empirical relationship between CDS and share price. Exhibit 2 plots five-year CDS premia versus an equity-implied fair value over time.

Exhibit 2

If the current levels fall below the fair value level, then we view CDS as too rich and/or equity as too cheap. Above the trend line, the opposite relationship holds.

At current levels, KBH CDS is rich (tight) to fair value. This bolsters our view of buying protection on KBH.

We note that the current CDS rich/equity cheap signal has been in place for a number of months and, given KBH's past behaviour, it may take some time for a return to fair value. We also caution that this statistical analysis lags the market and in times of dislocation – such as now – it takes time to "catch up" and, therefore, we do not solely rely on this simple fair value to make our assessment.

Taking equity price in distress into account, we build a hybrid fair value model that again estimates CDS levels based on equity share prices. Exhibit 3 charts market and fair CDS levels (y-axis) versus equity prices (x-axis). With CDS too tight when compared to equity, we expect a combination of shares rallying and CDS widening.

Exhibit 3

Hedging CDS with equity
Our analysis so far has pointed to a potential misalignment between the equity markets and credit spreads of KBH. It would appear that we should buy protection (sell credit) against a long equity position.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, our equity position will drop in value (bad for us), but this loss should be more than offset by our gain due to the CDS sell-off.

If equity rallies, we expect CDS to rally as well. Exhibit 4 charts the straddle-like payoff structure of the trade taking transaction costs and various months worth of protection paid into account. For simplicity, dividends are ignored.

Exhibit 4

The longer we hold the trade, the more difficult it will be to make money, given the negative carry/negative roll-down we face. However, given the volatility KBH is currently exhibiting, we believe we can exit profitably in a reasonably short time period.

The main trade risks are that KBH volatility drops and we are unable to unwind the trade profitably or that KBH begins trading under a different regime and the current equity-CDS relationship no longer holds.

Risk analysis
This position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall to US$0.75 as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mis-hedged position. It is our expectation that an LBO (however unlikely) would be a positive event for this trade, as we would expect CDS to sell-off and equity to rally.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and even further increase, which could lead to substantial return fluctuations.

Additionally, the trade faces a fairly substantial bid-offer to cross in CDS. The negative carry and rolldown hurt us the longer we hold the trade.

Negative carry: As constructed, this is a negative carry trade. We go long equity and buy protection, both of which cost us. The longer we hold the trade, the more difficult it becomes to recoup our costs.

Overall, frequent re-hedging of this position is not critical but the investor must be aware of the risks above and balance that with the negative carry. If dynamic hedging is desired, this is best achieved by adjusting the equity position given transaction costs.

Liquidity
Liquidity – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets – is a major driver of any longer-dated trade. Our data on liquidity – created from the volume of bids, offers and trades we see each day – provide us with significant comfort in both the ability to enter a trade in KBH and the bid-offer spread costs.

KBH is a highly liquid name and bid-offer spreads are around 10bp. KBH is also liquid in the equities market.

Fundamentals
This trade is more a bet on volatility than a bet on credit improving or deteriorating. With that said, we do see CDS as being too tight to fair value (or equity too cheap). Our expectation of a CDS sell-off is based on an empirical model and we turn to the company's fundamentals to see if that view is supported.

Vicki Bryan, Gimme Credit's Home Building expert, maintains a deteriorating fundamental outlook for KBH. She expects the housing market to remain weak into 2008 and notes that KBH might wait even longer for demand to pick up as it caters to entry-level home buyers. Vicki further notes that KBH has been responsible with its balance sheet and she expects that the company will maintain the strongest credit profile in the high yield space.

Summary and trade recommendation
Does anyone like homebuilders these days? Apparently, the credit markets do, given the rally we've seen since mid-August. Even as financials blow out to near their summer highs, the builders have only sold off modestly.

Since the credit crunch began last summer, KBH equity has been trading too cheap to CDS (or CDS trading too tight). This presents an ideal situation to employ our equity-CDS capital structure arbitrage model – buying CDS protection and buying equity shares. Given CDS is tight to fair value, the high equity volatility and the current alignment of debt and equity, we believe that a long equity/long CDS protection trade is the best way to capitalise on the disconnect.

Buy US$10m notional KB Home five-year CDS at 330bp.

Buy 42,800 KB Home shares at a price of US$26.35/share to pay -330bp of carry.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2007 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

What's in a mark?

Recent mark-to-market valuations are discussed by Corinne Cunningham and Tom Jenkins of RBS' credit research team

Merrill Lynch surprised the market with a larger than expected loss, but it also set the cat among the pigeons by taking huge losses on super-senior CDS exposure. Bond insurers have also been taking hits on their CDS exposures to sub-prime but at fractions of a percent. Both claim to be using mark-to-market valuations, so which is the more realistic?

Merrill Lynch's marks are heavy. While it is not possible to calculate the exact write down per tranche (as the bank did not give the starting position at the end of June or the change in exposure due to sale or hedge out during the quarter), Exhibit 1 gives a very rough approximation of the size of the marks being taken.

Exhibit 1

Contrast this with the monoline financial guarantors where mark downs ranged between only 30bp and 100bp, despite the underlying risks – on the face of it – not looking dramatically different (Exhibit 2).

Exhibit 2

AIG has yet to report. Relevant detail will include the US$64bn sub-prime element within the overall super senior CDS book and, within that, the US$19.5bn tranche backed by mezzanine sub-prime – but also the fact that AIG stopped taking on sub-prime exposure at the end of 2005, thereby avoiding the very worst mortgage assets. Taking the midpoint write down of the monolines at, say, 60bp would give a write down of US$2.8bn.

There could also be hits – although more manageable – in the insurance business from mortgage insurance and consumer lending, but the asset portfolio does not need to be marked to market.

To really evaluate the marks, you need to go deeper into the individual products, the structures including the precise underlying assets and the risk attachment points. The monolines have given a whole lot more detail on this front than the investment banks to better explain their exposures.

But even this level of analysis only partly explains the wide divergence in marks. The real difference probably lies in the likelihood that these instruments would be traded.

Investment banks marking trading books clearly need to take a mark somewhere close to the clearing level, as banks look to roll or exit the exposure. With few buyers on the other side, these marks are heavy and maybe wider than the realistic ultimate cash recovery value of the position.

Insurers (including monolines) need to mark derivative positions (including CDS) to market, but need not mark insurance risks or held-to-maturity assets unless there is judged to be a permanent reduction in value. A rating downgrade would almost certainly prompt a reassessment of values, as would a pick-up in underlying default rates. So far, insurers have not taken significant hits on the latter – although the recent wave of sub-prime and Alt-A rating actions could prompt some haircutting in Q4.

Monolines are, however, taking marks on their CDS exposures. Their CDS exposure is not directly comparable with banks – monolines generally try to underwrite CDS of CDOs on a 'pay-as-you-go' basis, which would pay interest shortfalls and principal when due (as with an insurance policy) rather than the full face value on first default. Hence the write downs are not on the same basis as the investment banks.

Insurers are in practice marking to model, although they are stressing the underlying models/assets in light of the rise in mortgage delinquencies. The valuations are therefore actually more akin to a cashflow recovery-based valuation than a here-and-now mark to market. That appears to be acceptable practice, provided the likelihood of loss is considered to be very remote (normally reference by AAA/AA ratings) and that there is no sense that the position will need to be unwound (i.e. sold).

Merrill Lynch has been hit worst out of all the investment banks with write-downs of US$7.9bn on sub-prime. This has raised questions as to whether other investment banks have understated their write-downs so far or whether Merrill is somehow unique. The answer is probably a bit of both, although the banks have not given a detailed enough breakdown of losses that would help with forecasting.

Pure US investment banks closed their Q3 figures at the end of August, whereas Merrill Lynch, the US universal banks and European banks have a September quarter end. The US investment banks therefore probably do have a bit more to take in Q4.

But Merrill may well have also had a weaker than average risk profile with respect to its mortgage book. Remember it acquired First Franklin in December 2006 with a view to building up its mortgage business.

On its conference call, the bank said it acknowledged that this was a mistake and tried to manage down its mortgage warehouse risk from January onwards. In doing this it constructed CDOs, kept the highest tranches and sold the lower ones.

Merrill said it insufficiently hedged the super senior pieces, hence its heavy write downs. From that, you can read that the underlying mortgages were on the weakest cohorts – H206 and H107 originations – which will also have contributed to the scale of the write downs.

How to position
The knee-jerk response would be to short all US investment banks right now – and that's the way the market is pushing today, taking the bigger banks with it on rumours that Citi will struggle to post adequate capital levels at year end. We certainly think it makes sense to stay short on those names most clearly exposed to continued mortgage market weakness (see Exhibit 3).

Exhibit 3

Other MTM phenomenon

Level 3 – going down?
"Level 3" is a FASB 157 construct dating from September 2006. All three levels of FASB 157 valuations are based on the exit price (for an asset, the price at which it would be sold) rather than an entry price (for an asset, the price at which it would be bought), regardless of whether the entity plans to hold or sell the asset.

FASB 157 further emphasises that fair value is market-based rather than entity-specific. Thus, the optimism that often characterises an asset owner must be replaced with the scepticism that typically characterises a risk-averse buyer.

FASB 157's fair value hierarchy underpins the standard. The hierarchy ranks the quality and reliability of information used to determine fair values – quoted prices are the most reliable valuation inputs, whereas model values that include inputs based on unobservable data are the least reliable.

Level 1: 'mark-to-market' – An asset valued via Level 1 will be a liquid instrument in a liquid market. It will have brokers quoting two-way prices.

Level 2: 'mark-to-model' – Will have some observable inputs, but cannot be priced via current trading (if the assets could be priced via trading, they'd be level 1). Will include quoted prices on similar instruments, or other inputs (for example, interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates).

Level 3: 'mark-to-make believe' – This asset pricing scheme uses "unobservable" inputs. You can't see the changes; instead, the banks use modelling and a leap of faith is required to believe the marks.

Booking gains on own credit spread widening
This is a carry forward from FASB 157, and is FASB standard 159 (since February 2007), with the intention of eliminating the artificial volatility when financial assets and liabilities are measured and reported differently in financial statements. FASB 159 thus allows banks an option of carrying certain (and at the option of the bank) financial assets and liabilities at fair value, with changes to fair value recorded in earnings.

Most of the provisions in FASB 159 are elective and not mandatory, and indeed the liabilities which may be recorded at mark-to-market valuations are, as mentioned, selectable.

FASB 159 can be applied instrument by instrument (but must be applied to the entire instrument and not just a portion of it), and it is irrevocable unless a new election date occurs. The standard allows for a one-time election for existing positions upon adoption, with the transition adjustment recorded to the first reported earnings thereafter.

This is, in our view, what we have seen in Q3; i.e. the first incidence adoption of FASB 159. What it also means is that from now on the banks must continue to mark the selected instrument to market.

Essentially it is saying that if it issued a note at par and that it could effectively buy this note back in the market at 85c, then it should be able to book this differential as a notional mark-to-market gain. The flip-side is that if this note trades up at 95c by year-end, the bank must book a 10c quarterly mark-to-market loss on the instrument.

© 2007 The Royal Bank of Scotland. All rights reserved. This Research Note was first published by the Royal Bank of Scotland on 1 November 2007.