News Round-up
LevX 2 draws closer
A round-up of this week's structured credit news
LevX 2 draws closer
A dealer call yesterday, 4 March, has confirmed that Series 2 of LevX – the European LCDS index – is scheduled to start trading on 17 March. The date of the roll was chosen three days earlier than those of the other CDS indices in order to spread the workload.
The new index will be based on the non-cancellable documentation, which lessens the chance of the underlying LCDS terminating early. The current series of LevX has been on the run for nearly 18 months as documentation issues were debated (see SCI issue 71), and it is still possible that the roll will be delayed beyond 17 March. LevX Series 2 is nonetheless expected to attract greater participation now that the substantial cancellation risk has been addressed, according to structured credit strategists at RBS.
Fitch reports on split ...
Much has been written about the potential break-up of one or more of the financial guarantors and the effect this could have on several different dimensions. In a new report, Fitch discusses some of the potential ramifications a split could have on protection purchased by banks and others, both from the financial guarantors (referencing assets including structured finance CDOs) and on the financial guarantors themselves.
"The current situation is highly fluid," says Fitch md Jim Batterman. "What has been of some concern to the market is that a negative reassessment of financial guarantor counterparty risk could effectively result in a significant reversal of mark-to-market gains for those institutions that purchased protection from the financial guarantors, such as the banks."
Further, while some of these same protection buyers and others may have also hedged their counterparty exposure to the financial guarantors through the purchase of protection on the financial guarantor (or its holding company) itself, consideration needs to be given to some of the nuances of ISDA language – particularly in regard to settlement and succession – should these businesses be broken up.
... while ISDA publishes monoline supplement
ISDA has published the CDS Monoline Supplement Agreement, incorporating by reference either one of the 2003 ISDA Monoline Provisions or the 2005 ISDA Monoline Supplement. The Agreement is designed to ensure operational efficiency in confirming trades on a consistent market standard.
The provisions and supplement effect certain changes to the 2003 Credit Derivatives Definitions to provide, among other things, that obligations guaranteed by a monoline insurer under a qualifying financial guarantee insurance policy or a similar financial guarantee would be deliverable on the occurrence of a credit event on the insurer. By signing the agreement, parties will expedite the process of due diligence of contract terms that would be necessary in such an event. Since most market participants are both buyers and sellers of protection, this 'good housekeeping' exercise is to the benefit of the entire market.
Fitch action affects US$97bn SF CDOs
Following continued deterioration in the sub-prime and Alt-A RMBS markets, Fitch initiated a global review of 430 SF CDOs with exposure to RMBS. The agency has consequently placed US$97bn of rated notes, comprised of 902 tranches, across 197 transactions on rating watch negative.
This action reflects the continued credit deterioration in US sub-prime mortgages, as recently revealed in heightened loss expectations and resultant rating actions. The combination of declining home prices and high risk mortgages are principal drivers of increased loss expectations for sub-prime RMBS.
In light of this on-going deterioration, Fitch's RMBS group announced increased loss expectations of 21% and 26% of initial securitised balances for sub-prime RMBS from the 2006 and 2007 vintages respectively. Accordingly, the agency placed US$139bn of 2006 and 2007 sub-prime RMBS on watch negative. As of 25 February, Fitch completed rating actions on approximately 80% of these tranches with 1,913 RMBS bonds being downgraded an average of 8.6 notches, 366 RMBS bonds affirmed and 91 RMBS bonds remaining on watch negative.
In placing SF CDO transactions on watch negative, Fitch primarily considered exposure to sub-prime RMBS and other SF CDOs with underlying exposure to sub-prime RMBS. The agency notes that credit deterioration of the underlying sub-prime RMBS securities may be amplified at the SF CDO-level, due to the use of leverage as well as structural features, such as overcollateralisation (OC) haircuts and OC-based event of default (EOD), which may adversely impact certain rated notes and CDOs containing these notes.
Further, Fitch's higher loss forecasts are expected to result in widespread and significant downgrades among the sub-prime RMBS bonds still on watch negative, and may affect all levels of the sub-prime RMBS capital structure. This was taken into consideration in identifying watch negative candidates, especially with respect to high grade SF CDOs, which tend to be thinly capitalised.
Other factors considered in the watch negative process included the worse-than-expected and still rising level of negative credit migration of Alt-A mortgage loans. In fact, a significant number of Alt-A transaction has been downgraded, placed on watch negative or 'Under Analysis' by either Fitch or the other rating agencies.
In total, this rating action affects 140 cash/hybrid transactions and 57 synthetic transactions. The bulk of these transactions was originated in 2007 (23 transactions), 2006 (48 transactions) and 2005 (49 transactions). The remaining transactions were originated in 2004 (36 transactions), 2003 (25 transactions), 2002 (14 transactions) and 2001 (two transactions).
Further analysis shows that US$42.8bn of rated notes on watch negative is from US mezzanine transactions and CDO-squared transactions backed by mezzanine SF CDO tranches. US$37bn of the rated notes placed on watch negative are from US high grade transactions and CDO-squared transactions containing high grade SF CDO tranches.
Tranches of European SF CDOs placed on watch negative total US$16.2bn. Finally, US$1bn of rated notes on watch negative is from one Asian SF CDO.
Of the US$97bn of rated securities or 902 tranches placed on watch negative, US$67bn of rated notes or 652 tranches were previously downgraded in November 2007 when Fitch undertook a global review of the SF CDOs it rates. As such, these notes are expected to experience relatively moderate downgrades.
That said, high grade sub-prime RMBS, high grade prime/Alt-A, as well as high grade and mezzanine CDO-squared transactions are expected to suffer comparatively more severe rating downgrades. Still, the characteristics of the exposure (size, vintage, seniority, borrower quality, country of origination) as well as the structural features of the specific SF CDO will ultimately determine the magnitude of rating downgrades. The resolution of this watch negative action will reflect the rating actions taken on the underlying RMBS assets.
Mazarin and Barion rated ...
Moody's and S&P have assigned provisional P-1/Aaa ratings to the US$40bn senior note programmes (Euro and US CP and MTNs) of Mazarin Funding, HSBC's restructured SIV vehicle. At the same time, S&P has assigned provisional ratings to Barion Funding (the sister vehicle of Mazarin).
Mazarin is committed to maintaining sufficient sources of liquidity to cover interest and principal payable on ABCP and MTNs plus interest payable on deferrable junior senior notes, Moody's says. Liquidity must be provided by Prime-1 rated financial institutions with same-day availability and no cancellation and limited default clauses.
If a liquidity facility provider is no longer rated Prime-1, the liquidity provider must take action to find a replacement with the appropriate ratings within 30 days of the downgrade. If it is unable to do so, Mazarin would be expected to draw on the liquidity facility.
Investors in ABCP and MTNs issued by Mazarin are exposed to liquidity risks arising out of the funding by Mazarin of longer-term assets with short or medium-term liabilities. If the vehicle becomes unable to finance its activities through the issuance of new liabilities to repay maturing liabilities it must draw under its liquidity facilities. The ability of Mazarin to draw on these facilities will depend on the performance by and the credit quality of the liquidity provider and failure by the liquidity providers to make advances pursuant to the terms of the liquidity facilities may adversely affect the noteholders.
The initial liquidity facility will be provided by HSBC. The maximum amount available under the liquidity facility will be determined by a borrowing base, which is calculated as the lesser of: the aggregate nominal amount plus accrued interest in relation to all assets rated Caa1 or higher; and the nominal amount plus yield for the senior debt plus fees, costs and expenses.
Mazarin may draw under the liquidity facility for any reason, other than to pay any principal in respect of a deferrable junior senior note or any amount in respect of an income note. Credit enhancement for Mazarin will be dynamically calculated based on achieving the necessary targets calculated using HSBC's own model – a multi-period simulation model that takes into account, among other things, credit risks and asset cashflows.
HSBC will monitor the credit quality of its portfolio on a frequent basis and will not be permitted to issue new senior notes at any time the credit enhancement for the senior notes is below that required by the model. Moody's has determined that the credit enhancement provided, by way of subordination, to the senior notes in relation to the initial portfolio is commensurate with the ratings. Initial subordination will be approximately 9.8%. Unrated capital notes and deferrable junior senior notes (rated triple-B by S&P) issued by Mazarin provide additional funds for investment and credit enhancement for investors in the senior notes.
S&P has also assigned its credit ratings to the deferrable junior senior notes, and the Tier 1 (class B) income notes issued by Barion Funding. At issuance, Barion used the note proceeds and the repurchase facility agreement to fund the purchase of an asset portfolio. The amount transferred was around US$7.6bn.
Under the repurchase facility agreement, the repo counterparty (HSBC Bank) agrees to transfer cash to Barion, which is used to fund the transfer of assets from Cullinan to Barion. In exchange, Barion repos these same assets to the repo counterparty.
"The main rationale for transferring Cullinan's assets into two new vehicles, Barion and Mazarin, is to eliminate market and liquidity risk to investors, via the support of HSBC as repo counterparty to Barion and as liquidity provider to Mazarin," says S&P credit analyst Lapo Guadagnuolo.
... while Parkland and Links senior debt affirmed
Moody's has affirmed the Aaa and Prime-1 ratings assigned to the MTN programmes and the Prime-1 ratings assigned to the CP programmes of the Parkland Finance and Links Finance SIVs. At the same, the agency has downgraded the ratings of Links' mezzanine and standard capital notes to Ba2 and C respectively.
The ratings affirmations reflect the provision of liquidity facilities for the vehicles by their sponsor Bank of Montreal. Under the liquidity facility agreement, CP and MTNs are fully supported by Bank of Montreal's commitment to provide loans to repay the paper as it falls due in conjunction with an orderly unwinding of the vehicles' asset portfolios.
Moody's is comfortable that, consistent with the ratings assigned, the commitment will equal the outstanding amounts of CP and MTNs less cash held and is available to be drawn up to its full amount independent of the market value or credit quality of assets in the underlying portfolio. The support of Bank of Montreal will enable the vehicles to avoid any realisation of current or future mark-to-market losses which could erode their credit quality, the agency says.
The negative rating actions in relation to Links' capital notes follows a decline in the net asset value of capital (calculated as the current mark-to-market value of the portfolio minus the book value of senior debt outstanding, divided by the book value of capital) from 78% on 30 November 2007 to 45% on 22 February 2008. The downgraded rating levels reflect the continued deterioration of asset prices and the subordinated nature of the notes, as well as the fact that they do not benefit from the liquidity facility agreement.
Moody's gives Ambac more time ...
Moody's says it has concluded its analysis of the residential mortgage and mortgage-related CDO exposures of Ambac Assurance Corp, and is continuing the review for possible downgrade that was initiated on 16 January. Based on an updated assessment of Ambac's mortgage risk, the agency believes that Ambac's capital exceeds the minimum triple-A standard but falls below the triple-A target level.
As outlined in Moody's previous communications with the market about such situations, it is the agency's practice to evaluate plans the company is pursuing to close the gap between actual capitalisation and target levels, including the certainty of those plans and the timeframe over which they would likely be realised. Ambac is actively pursuing capital strengthening activities that, if successful, are expected to result in the company meeting Moody's current estimate of the triple-A target level. The agency's continuing review will focus on both the further refinement of, and execution of, those capital plans, as well as on substantive changes that Ambac is implementing to its risk and operating strategies going forward.
Based on the risks in Ambac's portfolio, estimated stress-case losses would approximate US$12.1bn. This compares to Moody's estimate of Ambac's claims paying resources of approximately US$13.7bn, resulting in a total capital ratio of 1.13x, which exceeds the minimum triple-A level, but is short of the 1.3x triple-A target level by about US$2bn. Moody's further noted that in the most likely or "expected" scenario, Ambac's insured portfolio will incur lifetime losses of approximately US$4.2bn in present value terms, and that Ambac's current claims-paying resources cover this expected loss estimate by about 3.2x.
In Moody's opinion, Ambac's significant exposure to mortgage-related risk has had consequences for its business and financial profile beyond the associated impact on capitalisation, and affects its opinion about Ambac's other key rating factors. Nonetheless, despite some of the recent challenges faced by the company related to investor confidence, Moody's believes that Ambac is better-positioned relative to certain less-established competitors with respect to business franchise, prospective profitability and financial flexibility.
With respect to underwriting and risk management, Moody's believes that Ambac's significant exposure to the mortgage sector is indicative of a risk posture greater than would be consistent with a triple-A rating going forward. The company's participation in several 2007 vintage CDO-squared transactions, in particular, contributed to this view.
Moody's expects Ambac to implement significant changes to its underwriting and risk management guidelines to reduce volatility in its insured portfolio, including the exit from certain types of structured finance business, as well as tighter risk controls around the structured finance business the company intends to pursue going forward. In Moody's opinion, it will be critical for the company to focus on reducing single risk concentrations across its portfolio. The agency also believes that Ambac's non-core asset management activities, including GICs and interest rate and total return swaps, place incremental negative pressure on its ratings.
Prospectively, Ambac's profitability is likely to remain below historical levels over the near to intermediate term, particularly given the reduced issuance volumes generally, and investor caution about financial guarantors with mortgage-related exposures. It is uncertain how long this situation will persist. However, some earnings stability is provided by Ambac's large in-force portfolio, which will continue to provide significant premium revenue even if new business production remains sluggish over the near term.
Ambac could elect to pursue public finance and structured finance businesses through distinct legal entities. The ratings appropriate for separate insurers operating under such a strategy would depend on their specific business and financial characteristics, including capitalisation and underwriting frameworks. In this scenario, Moody's believes that the structured finance guarantor would be more challenged than its public finance affiliate to maintain a triple-A rating, due to the relatively greater complexity of risks and higher risk concentrations evident in that sector of the market. The effect of these structural changes would likely be to reduce the risk of downgrade for the guarantor's insured municipal debt and to increase the risk of downgrade for the insurer's other exposures.
Ambac, responding to Moody's announcement, confirmed that it is actively pursuing a plan to further augment its capital resources in order to achieve the triple-A target. The monoline announced it is to reduce its quarterly dividend to 1c per share from 7c and that it will suspend all structured finance business for six months, a move that is expected to free up US$600m of capital.
Meanwhile, New York Insurance Superintendent Eric Dinallo is reportedly working on implementing a new set of regulations for bond insurers by the middle of the year. In general, changes are likely to be with a view to protecting policyholders, so a positive for those long risk at the insurance company level but potentially a negative for those long risk at holding company level, say investment grade analysts at RBS.
... but reviews SCA
Moody's has placed the A3 insurance financial strength ratings of the operating subsidiaries of Security Capital Assurance, including XL Capital Assurance, on review for possible downgrade. The agency is also reviewing for possible downgrade the debt ratings of the holding company and a related financing trust.
As a result of this review for possible downgrade, the Moody's-rated securities that are guaranteed by XLCA are also placed on review for possible downgrade, except those securities with public underlying ratings of A3 or higher.
The rating action was prompted by SCA's recent SEC filing which stated that the company has delayed the filing of its 2007 Form 10-K and that the company's independent auditor is evaluating the need to include a going-concern explanatory paragraph in its audit opinion with respect to SCA's audited financial statements for the year ended 31 December 2007. A going-concern explanatory paragraph indicates that the auditor concludes that there is substantial doubt regarding the entity's ability to continue as a going concern for a reasonable period of time without substantial disposition of assets outside the ordinary course of business, restructuring of debts, externally forced revisions of its operations or similar actions.
Moody's notes that SCA's disclosure suggests that it has not yet been determined whether a going-concern paragraph will be included in the auditor's opinion letter, nor does it indicate what the rationale for a going-concern paragraph would be. Nonetheless, the fact that the need for such a paragraph is being evaluated by SCA's auditor is further indication of disruption in the company's operating profile.
The company also noted in its filing that it expects to incur approximately US$1.5bn of net mark-to-market losses on its credit derivative portfolio, including approximately US$645m in net credit impairment charges, as well as US$44m in net losses arising from its direct RMBS exposures – primarily from transactions backed by second-lien mortgage collateral. The magnitude of credit impairments announced by SCA falls within the range of losses previously considered by Moody's in its rating action of 7 February 2008, when the insurance financial strength rating was downgraded from Aaa to A3.
According to Moody's, the ratings review will focus on developments related to the potential issuance of a going-concern explanatory paragraph by SCA's auditor, as well as additional details related to SCA's capital plans and strategic direction.
Stable/negative outlook for US CLOs
The outlook for US cashflow CLOs is stable/negative, with limited implications for ratings, says Moody's in its annual sector review and outlook report on the asset class. The move comes as another two transactions begin marketing: Cohen Brothers' US$291m Emporia Pure CLO and Highland Capital's US$516m Aberdeen Loan Funding.
"Despite the potential for downward rating pressure, we do not anticipate dramatic changes in CLO rating performance in the year ahead," says Lina Kharnak, a Moody's vp-senior analyst. "Historically, CLOs have demonstrated considerable rating stability, even during highly stressful credit environments such as 2001-2002."
The downward rating pressure could arise for certain notes if rising corporate defaults and significant credit deterioration lead some collateral pools to trip the triggers on their overcollateralisation tests, leading to prepayment of senior notes to the exclusion of cashflows for the equity and, frequently, mezzanine notes. This stabilises the ratings of the senior notes but potentially pressures those of the junior notes.
"A continued negative ratings drift in the underlying collateral may pressure the ratings on certain CLO liabilities," says Kharnak. "But currently we do not expect this downward pressure to be sufficient to induce significant, widespread downgrades of CLO liabilities."
As for issuance of new CLOs in 2008, Moody's expects levels to be subdued in the near term. Persistent market volatility may continue to widen spreads on both leveraged loans and CLO liabilities, regardless of underlying credit fundamentals. CLO issuance will be relatively weak as long as these liability funding costs remain uneconomically high.
"Overall, we may see some pick-up in leveraged loan CLO origination in the second half of 2008, if the US economy shows signs of stabilisation and the sub-prime-linked credit problems are contained," says Kharnak. "However, we do not anticipate a return to the pace of issuance seen during 2006 and the first half of 2007 in the near future."
In 2007, Moody's rated 174 US cashflow CLOs, with a total rated volume of approximately US$91bn. During 2007, the agency says the CLO market continued to show reliable credit performance, despite being caught up in the sub-prime mortgage turmoil that has disrupted credit markets since mid-year.
Japanese bank earnings constrained
Earnings at Japan's major banks were constrained by downward pressure from expanding sub-prime loan-related losses in the third quarter of fiscal 2007. However, the major banks have built up sufficient reserves to counter any additional write-downs stemming from sub-prime loans.
In addition, S&P expects the banks to be able to cover any further sub-prime-related losses with existing revenues. As such, attention is now shifting to the widening aftershocks of the sub-prime loan problem, and the agency is focusing on the quality of loans, corporate bonds and overseas securitisation transactions.
In the first half of fiscal 2007 (ended 30 September 2007), aggregate sub-prime loan-related losses at the six major Japanese banks amounted to about ¥100bn. These losses ballooned to ¥519bn as of end-2007.
During the third quarter, the major banks' exposure to sub-prime loans decreased slightly from about ¥930bn at the end of September to roughly ¥700bn at the end of December. This was equivalent to about 3% of the major banks' aggregate Tier 1 capitalisation, which was much lower than that of major overseas banks (40%-80% of Tier 1 capital) that experienced ratings or outlook revisions.
The degree of impact on Japan's major banks from the sub-prime loan problem in the US varies greatly. For example, both Chuo Mitsui Trust & Banking Co and Resona Holdings have little or no sub-prime-related losses respectively. Conversely, the greatest impact was felt by Mizuho Securities Co, which handles RMBS and CDOs.
Mizuho FG posted ¥345bn in losses, or 57% of net operating profit, due to global market volatility during the April-December period of 2007. Moreover, Mizuho Securities faces the possibility of additional losses, despite its write-down of losses incurred thus far. The company was holding ¥160bn in CDOs backed by RMBS and ¥180bn in RMBS as of end- 2007.
Mitsubishi UFJ Financial Group has the second-largest exposure to sub-prime mortgage loans among the three largest Japanese financial institutions, holding ¥246bn in RMBS and ¥39bn in SIV investments. However, the bank has stated that its RMBS holdings consist of top-rated primary securitised paper that has a lower loss ratio than its secondary securitised products.
Despite the emergence of ¥95bn in total sub-prime loan-related losses at Sumitomo Mitsui Banking Corp, given its relatively rapid treatment and after adjusting for provisions, the remaining exposure is the smallest among the three largest Japanese financial institutions.
Since January 2008, residential property prices in the US have fallen and the housing market crisis has deepened. Between January 2007 and February 2008, S&P lowered its ratings on a large number of RMBS and CDO transactions. Furthermore, the agency believes it is likely that losses from securitisation transactions will increase over the coming months, and may lead to further losses at regional banks in the US, as well as at certain European and Asian banks.
The likelihood for any surprises at major Japanese banks is low, given that they are evaluated using market values as guidelines, and that their loss ratios are similar to those of major overseas financial institutions. As of end-2007, Mizuho FG wrote down the value of its CDOs carrying RMBS deals as collateral by 44%. This compares well with the average write-down among major overseas financial institutions.
In contrast, downgrades of monoline insurance companies that provide guarantees on securitised assets could result in additional losses at global financial institutions. S&P believes, however, that the impact of potential downgrades of monoline insurers on Japanese banks would be limited.
Yet there are two main issues of concern. First, if a bank holds financial products guaranteed by a monoline insurance company, losses may be incurred if the market value of those products declines.
The aggregate balance of the monoline-related loans and investments held by the major Japanese banks was about ¥700bn, which accounted for only about 2% of total regulatory capital as of September 2007. Considering the soundness of the underlying assets and the credit level of the monoline insurance companies, S&P estimates the price deterioration risk of these financial products to be lower than those backed by sub-prime loans.
Second, banks that purchased protection from monoline insurance companies based on CDS contracts to hedge investment risk incur provision costs due to the deterioration of the insurers' credit quality. Notably, the degree of impact of the insurance companies' credit risks increases in proportion to the degree of deterioration in the value of the reference obligation. Merrill Lynch and Citigroup have incurred large losses from CDS contracts that hedge risk on the super-senior portions of their CDOs.
In the third quarter of fiscal 2007, two of the major Japanese banks recorded a provision of reserves for possible losses against protection from monoline insurers. Mizuho FG recorded provisions of ¥49bn against CDS agreements with counterparties rated below investment grade that included a ¥70bn CDS contract.
Meanwhile, Sumitomo Mitsui Financial Group recorded provisions of about ¥10bn against a ¥20bn monoline hedge exposure. Although additional provisions may be required depending on market prices of reference obligations and the credit quality of the monoline insurers, the impact on the bank's credit quality should be limited.
The direct risk exposure of major Japanese banks to sub-prime- and monoline-related assets is not large. However, the impact from these products may increase if the spreads widen for other securitised products and corporate bonds due to downgrades of monoline insurance companies and a deterioration in the US economy.
Overseas securitised products held by major banks are estimated at about ¥5.9trn as at end-2007 (excluding sub-prime loans and agency bonds). The price deterioration risk for these securitised products may be smaller than the risk of losses from sub-prime-related assets. Nevertheless, given the increased defaults on credit cards, automobile financing and mortgage loans, S&P believes a decline in quality is likely.
ARM prepayments slow
The rate of prepayments on sub-prime adjustable-rate mortgage (ARM) loans originated since the middle of 2005 has been markedly slower than for loans originated in preceding years, Moody's says in a new report. The agency expects the low prepayment rates to continue.
Moody's says the prepayment rates for the pools of loans backing RMBS have been falling with each successive year of origination since 2005. For example, the constant prepayment rate (CPR) for the 2006 vintage of RMBS 15 months after securitisation was less than half the average CPR for the prior four vintages at the same time since issuance.
The slowdown in prepayments, if it persists, will be one of the contributors of potentially higher losses for sub-prime RMBS transactions, says Moody's. The agency explains that, historically, the vast majority of prepayments occur when borrowers either refinance their existing mortgages or sell their homes. With adjustable rate mortgages, prepayments have tended to spike around the 24th month, as borrowers refinance to avoid what are often steep payment resets.
"Many borrowers who took out ARMs did so with the belief that they would be able to refinance their loans at reset," says Moody's associate analyst Karandeep Bains. "Without that ability to refinance, those borrowers might not be able to make the higher payments after reset and will have a higher likelihood of becoming delinquent."
Several factors are combining to slow the rate of refinancings and hence prepayments, says Moody's. First, the deterioration in the housing market has led many homeowners that bought their homes at higher prices in late 2005 or 2006 to have little or negative equity in their homes, making their refinancing difficult.
Second, lenders have tightened their lending standards as the housing market has slowed down. And third, the recent credit crunch has caused several large lenders to close their mortgage origination businesses entirely, reducing the number of lenders offering sub-prime loans for refinancing.
Some developments that might help increase prepayment speeds are active loan modifications on the part of loan servicers and federal policy changes, such as the new FHA Secure programme to guarantee loans of borrowers with strong credit histories. However, it is not clear that lenders will use loan modifications to a large enough extent to have a significant impact on the market's overall credit performance, says Moody's.
Rating change index report
Fitch says that the global credit crunch affected European structured finance (ESF) ratings during the final quarter of 2007 and was focused almost entirely on the CDO sector, particularly structured finance CDOs. The agency's latest quarterly update for its ESF Index of Rating Change shows a decline of 8.7% in the quarter, even though there were 158 upgrades and 128 downgrades. The index measures the weighted average change in the Fitch rating factor across all ESF transactions with a public rating by the agency.
"Out of the 128 downgrades, 125 affected CDOs and 54 of them involved a rating change of 10 notches or more – reflecting the impact of the problems in the US sub-prime sector on certain structured finance CDOs," says Rodney Pelletier, md in Fitch's structured finance team.
The index for the remaining three asset classes – ABS, CMBS and RMBS – together rose 0.6% as a result of 138 upgrades, mostly on small junior classes, and only three downgrades, each by one or two notches. Across the whole of ESF, 5,778 tranches with a value of €1bn had no change in their ratings during the quarter.
The index for CDOs alone fell 22.3%, reflecting a number of multi-notch downgrades to low rating levels – where the slope of the Fitch rating factor curve becomes steeper. The ABS index rose 0.7%, the RMBS index was up 0.6% and the CMBS index rose 0.4%.
"While the impact of the credit crunch has shown up earliest among CDOs, slowing European economies and the restricted availability of credit may lead to increases in downgrades in coming quarters in ABS, CMBS and RMBS, albeit from very low levels," adds Charlotte Eady, associate director in Fitch's structured finance team.
Among major source countries, the index for Italy showed the strongest improvement, by 1.6%, while the Dutch and UK indices showed modest rises. The German index declined 2.6% as a result of downgrades of a series of SME CDO transactions.
Most CDOs are backed by broadly international collateral and are not attributed to individual countries.
BIS reports on CDOs
Bank for International Settlements has released its latest quarterly review. The report includes five special feature articles, all related to the recent financial turmoil: central bank operations designed to implement monetary policy; drivers of international interbank rates; interbank rate fixings; the spillover of money market turbulence to FX swap and cross-currency swap markets; and CDOs.
The latter states that recent, large-scale downgrades of structured finance CDOs are a reminder that rating transitions for structured finance products can be much more pronounced than those for more traditional credit instruments. In their analysis of the linkages between credit fundamentals, ratings and value-at-risk measures both for CDO tranches and for corporate bond exposures, Ingo Fender, Nikola Tarashev and Haibin Zhu of the BIS suggest at least two reasons for this.
First, the tranching process results in a non-linear relationship between the credit quality of the underlying assets and that of the tranched products. Second, ratings of tranched products are more sensitive to systematic risk. The authors conclude that undue reliance on ratings can lead to mispriced and mismanaged risk exposures, as well as unfavourable market dynamics if these exposures have to be unwound.
SF CDO performance unlikely to improve
SF CDOs performance is unlikely to turn around in 2008 as the difficult market conditions that prevailed during the second half of 2007 remain, says Moody's in its annual sector outlook and review report on CDOs. In fact, the agency expects to see significantly negative rating activity on SF CDOs during 2008, given its higher loss projections on sub-prime and Alt-A mortgages.
Moody's also expects continued deterioration in corporate credit quality in 2008, which may negatively affect the ratings of synthetic CDOs backed by pools of corporate names. However, cashflow CLOs which have built-in credit protection measures are not expected to experience widespread downgrades, despite the rise in corporate defaults expected in the coming year.
The key question for 2008 CDO issuance levels in general, says Moody's, is at what point investor confidence will be restored. "A full recovery in the CDO markets is unlikely until the effects of the sub-prime mortgage crisis have been fully measured, especially the effects on financial institutions," says Moody's Jian Hu, an svp in the US Derivatives Group and the primary author of the report. "In addition to performance considerations, investor demand will also be driven by the market's capacity to respond to an increased desire for information transparency in terms of underlying and structural risks."
"While credit spreads have widened in general, the increases have been particularly sharp for CDO liabilities, resulting in much reduced relative arbitrage opportunities," adds Hu. Issuance of SF CDOs in the US is likely to be minimal in 2008, whereas that of synthetic corporate CDOs is expected to be much lower than those in 2006 and 2007.
Meanwhile, the issuance of cashflow CLOs will become increasingly active, but a lot will be dependent on the conditions in the primary leveraged loan market and the arbitrage opportunity of structuring CLOs. In general, Moody's expects the bulk of CDO issuance in 2008 to be cashflow CLOs and synthetic corporate CDOs.
Troubled company index rises
Kamakura Corporation says that its monthly index of troubled public companies increased again in February, rising 0.2% to 12.3% of the global public company universe. This is the ninth rise in the troubled company index in the last 11 months.
Current credit conditions are better than only 50.3% of the monthly periods since the start of the index in January 1990. Credit conditions remain at their worst level since December 2003. The all-time low in the index was 5.4%, a level reached in April and May 2006.
Kamakura defines a troubled company as a company whose default probability is in excess of 1%. The index covers more than 20,000 public companies in 29 countries using the fourth generation version of the company's advanced credit models.
"The market continues to teeter on the brink of a recession, with credit conditions barely better than the average for the last 18 years," says Warren Sherman, Kamakura president and coo. "In February, the percentage of the global corporate universe with default probabilities between 1% and 5% declined by 0.2% to 8.5%."
ABX/TABX CLNs downgraded
Moody's has downgraded the ratings of 34 credit-linked notes and three credit default swaps with respect to which the reference obligations are ABX.HE 07-1, ABX.HE 06-2, ABX.HE 06-1 or TABX.HE 07-1 06-2. 25 of these ratings have been left on review for downgrade.
The ABX.HE and TABX.HE indices are static and are 100% exposed to sub-prime RMBS issued in 2005 and 2006. In response to continued credit deterioration of first-lien sub-prime residential mortgages securitised in 2006, Moody's has increased its loss projection for these loans to the 14-18% range. These rating actions reflect the agency's updated loss projections for the reference obligations and the increased expected loss associated with each security.
Further European S&P downgrades
S&P has taken credit rating actions on 88 tranches of European synthetic ABS CDOs. Specifically, the ratings on: 57 tranches were removed from credit watch with negative implications and lowered; 17 tranches were lowered and remain on watch negative; six tranches were lowered; and eight tranches were removed from watch negative and affirmed.
The 88 tranches represent 2.95% of the total number of European synthetic CDOs that S&P rates. The affected transactions reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. The CDO downgrades reflect changes that S&P has made to the recovery rate and correlation assumptions it uses to assess US RMBS held within CDO collateral pools.
US CRE CDO delinquencies rise again
An increase in performing and non-performing matured balloon loans drove the US commercial real estate loan (CREL) CDO delinquency rate for February 2008 to 0.93%, up again from last month's rate of 0.70%, according to the latest CREL CDO Loan Delinquency Index (LDI) from Fitch Ratings. In addition to the matured loans mentioned, the LDI includes loans that are 60 days or greater delinquent and repurchased loans.
Further, Fitch noted 47 reported loan extensions in February 2008. The majority of the extensions were options contemplated at closing (provided certain conditions were met); however, approximately 20% of these extensions were modifications from the original loan documents. The increase in loan extensions, together with the higher number of matured balloon loans, reflects the lower available liquidity in the commercial real estate market.
Although the overall delinquency rate for CREL CDOs remains low, it is more than three times the US CMBS loan delinquency rate of 0.27% for January 2008, which was a historical low. February 2008 is the third consecutive month in which the index has increased.
The CREL CDO delinquency index is anticipated to be more volatile than the CMBS delinquency index, given the smaller universe of loans and the more transitional nature of the collateral. The Fitch CREL CDO delinquency index tracks approximately 1,100 loans, while the Fitch CMBS delinquency index covers over 40,000 loans.
The February 2008 loan delinquency index encompasses 14 loans, which include five loans that are 60 days or more delinquent, seven matured balloons and two repurchased loans.
There are six new matured balloons, including three loans secured by interests in the same collateral – the EOP Macklowe portfolio. The loans, which are secured by interests in four high quality office buildings located in Midtown Manhattan, matured on 9 February. The borrower has reportedly been served with a notice of default by at least one of its lenders.
Interests, including one B-note and two mezzanine positions, can be found in three separate Fitch rated CREL CDOs. Of the other matured balloon loans, one was repaid in full after the cut-off date for this report, while the other three – including one that appeared in last month's LDI – have either been extended or requested an extension.
Asset managers also reported that two assets (0.17%) were repurchased from two separate CDOs in February 2008. One of the loans was included in the January 2008 LDI as a matured balloon loan. The other repurchased loan was removed to facilitate a loan modification and extension outside of the CDO.
However, given the illiquidity in the market, Fitch expects fewer repurchases of troubled loans and more workouts within the trust.
Although not included in the loan delinquency index, 11 loans – representing 0.52% of the CREL CDO collateral – were 30 days or less delinquent in February 2008. This statistic is up significantly from last month's total of 0.15%. While five of these loans were brought current after the cut-off date for this report, the other loans suggest cause for concern for higher overall delinquencies next month.
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 cases where the probability of default was not already 100%.
Japanese CDOROM launched
Moody's has released CDOROM Japan v2.4. The tool is specifically tailored to Japanese synthetic CDOs.
While most of the functions of CDOROM Japan are the same as those of CDOROM, CDOROM Japan has two unique features. Most worksheets are shown in Japanese and it incorporates the 34 industry classifications that Moody's employs for portfolios of Japanese corporates, which are modifications of the classifications Moody's uses for global corporate portfolios. A new report describes the features of CDOROM Japan, in addition to providing an overview of the general CDOROM model.
QWIL income unchanged
Queen's Walk Investment Ltd has reported operating income of €9.7m for the quarter ended 31 December 2007, unchanged from €9.7m in the previous quarter. The company's net asset value remained unchanged at €6.90 per share.
Distributable income during the quarter was €7m, down from €7.6m in the prior period. Queen's Walk's board of directors has decided to maintain the dividend at the level of the previous quarter of €0.15 per share. Cash generation for the quarter was solid, with €21.4m of cash proceeds received.
Fair value write-downs of the company's investment portfolio for the quarter totalled €8.3m, up slightly from €8m for the period ended 30 September 2007. Write-downs were equivalent to approximately 2.6% of the 30 September 2007 gross asset value.
ISDA seeks to clarify UCITS CDS rule
ISDA has raised concerns on behalf of its members over the possible impact of Article 8(2)(b) of Directive 2007/16/EC (the Eligible Assets Directive or EAD) on the ability of funds regulated under the Directive 85/611 EEC on Undertakings for Collective Investment in Transferable Securities (UCITS) to access the senior unsecured CDS markets. In particular, ISDA is concerned as to whether the provisions of Article 8(2)(b) of the EAD should be read as preventing UCITS from investing in market standard CDS where the documentation states the deliverable obligation as bond or loan.
ISDA is consequently seeking further clarification on the intended effect of Article 8(2)(b) from the Committee of European Securities Regulators (CESR). The Association understands the policy position in limiting the financial derivative investments into which UCITS can invest in OTC derivatives where the underlying of the derivative is a financial instrument into which a UCITS may invest directly or a financial index.
However, Article 8(2)(b) of the EAD has caused concern because it states that OTC derivatives must not: "result in the delivery or in the transfer, including in the form of cash, of assets other than those referred to in Article 19(1) and (2) of Directive 85/611/EEC".
Such language could be interpreted to indicate that CDS whose reference assets are bonds, but which could result in the delivery or the transfer of a loan that does not meet eligibility criteria – even where that delivery takes the form of cash settlement – are no longer permitted to be held by UCITS. This wording raises concerns for both UCITS and dealer participants in the CDS markets.
ISDA has submitted on behalf of its members that the position should be that CDS have been, and continue to be, eligible assets for UCITS, provided that they are cash-settled with respect to the ineligible asset.
CS
Research Notes
Counterparty risk in credit derivatives - part 2
In the second of a two-part series on credit derivatives counterparty risk, Barclays Capital's quantitative credit strategy team estimates the risk in the system
Expected losses due to correlated defaults
Since they were introduced, credit derivatives have become increasingly popular with banks and investors as a way of managing risk. This, combined with their attractiveness as a clean way to express directional credit views, has led to exponential growth in their use.
The OTC nature of credit derivative contracts, however, makes it difficult to estimate accurately the total size of the market. Further, as counterparty risk arises only in the case of privately-settled contracts between two entities, it is in effect private information. This further compounds the difficulties of making any kind of estimate of the level of risk the financial industry faces as a whole due to counterparty defaults.
Using the methodology outlined in Part 1 of this series (see last week's issue) as well as overall market statistics released by the Bank for International Settlements, we try to approximate the total risk inherent in the system. We do this by estimating on an aggregate basis the expected losses to surviving entities when counterparties and reference credits both default.
Of course the assumptions highlighted previously introduce a high degree of uncertainty into the estimated loss number. Our analysis aims to provide a methodology for approaching the problem, and the figures are meant to be ball-park, not exact estimations of risk in the market.
The BIS releases bi-annual figures summarising estimates of OTC derivatives market statistics polled from broker/dealers in 47 jurisdictions, including the G10 and Switzerland. These figures allow some estimation of the total size of the credit derivatives market, as indicated in Figure 1.
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| Figure 1 |
Similar segmentation of the market is also available for the ratings of all reference credits on which there are outstanding CDS contracts. Assuming homogeneity between the distributions of counterparty and those of the reference, we can arrive at the following segmentation of the entire CDS market, as shown in Figure 2.
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| Figure 2 |
Given the average default probabilities for different segments and assumed correlation figures, we can calculate approximate values of the expected loss in each segment. For the type of counterparty categorised as 'Other financials', we assume a very conservative average rating of single-B minus, to reflect the inclusion of hedge funds in that segment (see Figure 3). We emphasise that all statistics reported by the BIS are from dealers/brokers, and thus the total loss estimation only includes those deals that have dealer/brokers as counterparty.
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| Figure 3 |
The first three columns of Figure 3 give the expected loss over one year as a percentage of notional for a counterparty and reference credit of the indicated types. This expected loss is calculated using the methodology described in Part 1.
The total expected loss in US$bn for a segment is arrived at by multiplying this loss figure by the total notionals outstanding for that segment. The highlighted total of US$80bn over the next year assumes 40% recovery for counterparties, 10% recovery for reference and an asset returns correlation of 0.8.
Stress testing these results
While the base-case scenario of US$80bn of losses provides an initial reference point to estimate counterparty risk on a systemic basis, we reckon there is even more information to be gained from observing how changes in the different assumptions affect this overall number. We present here a comprehensive set of stress-testing results on expected loss outcomes, obtained at different estimates of the input parameters.
The charts in Figure 4 summarise the sensitivity of the above base-case scenario to changes in the following parameters:
• Correlation. The correlation figure refers to the implied correlation of asset returns of financials with corporates (counterparty and reference). Figure 4a estimates the sensitivity of the total market loss to this assumption. The worst-case scenario is when financials-corporate returns are 100% correlated, making a double default very likely. In this case, the total estimated loss to the market is about US$108bn. A negative correlation of asset returns obviously reduces the estimated loss further; however, we do not think that this scenario is very realistic;
• Time horizon. As the likelihood of default of any entity increases with an increased time horizon, the total loss estimate to the system also increases. However, it is unrealistic to expect asset returns to remain as highly correlated as 80% over long periods of time. We thus modify our base-case scenarios by reducing the implied correlation assumption to 60% over two years and even further down to 40% over three years;
• Recovery rates. The effect of counterparty and reference recovery rates is theoretically symmetrical on the total system loss. Figure 4c summarises these effects;
• Default rates. Our calculations use market spread-implied default probabilities. We stress-test these assumptions by calculating the loss to the system at different multiples of the current implied default probabilities for both the counterparty and the reference entity. This accounts for deviations in future realised default rates from current spread implied rates.
In each of the charts, the base case itself is highlighted with the dashed circle.
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| Figure 4 |
Accounting for collateralisation
The biggest drawback of the analysis in the previous section is that it ignores all risk-management techniques used by banks - the most significant of which are the use of collateral and netting. It is very difficult to gauge the degree to which netting will aid a bank if a counterparty defaults; that will depend on specific exposures across asset classes that the specific bank has to the specific counterparty.
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| Figure 5 |
However, it is easier to estimate the effect of collateralisation. ISDA's Counterparty Risk Concentration Survey (May 2007) highlights the effects of collateralisation on the net market exposure of dealer/brokers (see Figure 5). Reducing the expected losses in Figure 3 by the proportions highlighted in the diagram, we arrive at a new base-case scenario for counterparty defaults, as indicated in Figure 6.
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| Figure 6 |
The new base-case scenario (with the same assumptions of correlation and recovery rates) indicates about one-fifth the amount of losses than before accounting for collateralisation. The sensitivities to different parameters are also recalculated in Figure 7.
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| Figure 7 |
Scenarios in case of an actual counterparty default
The previous section investigates the total risk to the financial system from potential correlated defaults in the next year. However, it is also of interest to determine what happens when an actual counterparty does default. The default of a major bank/broker would obviously affect the whole market, and the impact would not just be limited to credit derivative contracts but also other OTC contracts (some of which exist in far higher notionals that CDS contracts).
In this section we therefore assess the damage to the financial system from a failure of a major counterparty, say from large unexpected losses, write-downs and the failure to raise adequate capital. While we do believe that it is rather unlikely and hence consider it a tail-event risk scenario, it is nevertheless useful to assess what happens in such a situation.
Even in the absence of reference entity default, a failure of a major counterparty could lead to losses across the financial system. Upon the default of the counterparty, OTC derivatives would be immediately and significantly re-priced, with credit spreads likely widening dramatically. This means that CDS contracts would be terminated at a spread significantly higher than the spread at which collateral was last posted, leading to the crystallisation of significant losses.
The mechanics of gap risk loss on CDS positions
In this section we focus on losses which are crystallised due to a default-induced re-pricing of credit in the period between the last posting of collateral and contract termination. We assume the following scenario, which is illustrated in Figure 8.
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| Figure 8 |
Throughout the period before T1, a major counterparty buys and sells protection with a host of investors. These positions are fully margined and collateralised on a daily basis.
This implies that all daily MTM P&L is locked in and immune from risk from counterparty default. It also implies that all investors – in-the-money and out-of-the-money protection buyers and sellers – are exposed to the same gap risk from a counterparty defaulting.
This is the risk of spreads jumping significantly from levels at which the posting of collateral takes place and levels at which the contract is terminated. If a major counterparty defaults, we believe credit spreads are likely to re-price significantly and immediately.
In this scenario, both protection buyers and protection sellers face losses:
• Protection sellers realise the full loss of negative MTM resulting from the jump in spreads. As spreads gap wider, protection sellers incur a MTM loss, which they have to honour and pay to the defaulted counterparty as the contract is terminated.
• Protection buyers realise the loss equal to the foregone MTM profit from the jump in spreads, less the recovery of this profit from the defaulted counterparty. As spreads gap wider, protection buyers make a MTM gain, which they do not receive from the defaulted counterparty. They make a claim on this MTM profit on the defaulted counterparty and they receive certain recovery value on this in due course.
Illustrating potential gap risk losses on CDS positions
The total notional amount outstanding of OTC credit derivatives for broker/dealers is US$42.5trn. There are approximately 55 broker/dealers who buy or sell protection. In this exercise we analyse a scenario where a relatively large counterparty defaults.
We assume that this counterparty sold US$1trn of protection and bought US$1trn of protection. We further assume that the proportion of IG protection sold by the counterparty is 65% (please refer to Figure 2) and the average life of contract affected is five years. We continue to assume that the recovery rate on the counterparty is 40%.
We believe that a default of a major counterparty would cause a significant re-pricing in credit. Although consequences of such an unprecedented event are difficult to quantify, we estimate losses for a variety of scenarios.
In our analysis, we allow the IG credit spreads to jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of 30-40bp as the most likely in case of a default of a counterparty with US$2trn of outstanding CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads could jump between 40bp and 240bp, with 120-160bp being most likely (Figure 9).
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| Figure 9 |
Our analysis shows that the failure of a major counterparty which had US$2trn outstanding in OTC credit derivatives, could result in losses of US$36-47bn in the financial system solely because of the immediate re-pricing of credit risk due to a counterparty default (Figure 10). We stress that these losses are crystallised by investors who had exposure to the defaulting counterparty.
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| Figure 10 |
Additional to these, there would also be large, potentially concentrated, MTM losses for investors without exposure to the defaulting counterparty. These losses would result from a re-pricing of risk, which we do not account for here.
However, we would add the caveat that netting could significantly reduce our estimated losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.
There are two factors which could cause the realised losses to be larger than our estimates. The first is the fact that, while we assumed full collateralisation, in reality collateralisation is imperfect. This would mean that at the point of last posting of collateral, there would be some MTM positions which are not backed by collateral and any losses on these positions would increase the loss from gap risk.
The second is forward margining. Any collateral posted by hedge funds with the defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of collateral less recovery.
Other derivative contracts could be significantly affected
Thus far in our analysis we have concentrated solely on credit derivatives. However, in terms of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives, with interest rate derivatives constituting the largest proportion of 67%.
We believe that a default of a major counterparty would cause a significant re-pricing in all OTC derivatives. This implies that these contracts would also be vulnerable to large gap risk. Given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant.
© 2008 Barclays Capital. This Research Note was first published by Barclays Capital's quantitative credit strategy team on 20 February.
