News Round-up
Slower remittance deterioration, but increased apathy?
A round up of this week's structured credit news
Slower remittance deterioration, but increased apathy?
Analysts report a moderating trend in the July Markit ABX remittance data, despite three more index constituents experiencing principal write-downs over the last month. However, the fact that the index failing to roll once again seemingly went unnoticed by the market is seen by some as a sign of its indifference.
When the ABX failed to roll into a 2008-1 index, the market met the failure with some degree of concern, note structured finance analysts at Wachovia Capital Markets. "This time around, no-one seemed to notice the failure of 2008-2. We take this as a sign of resignation and indifference to the ABX," they say.
One CDS trader adds: "ABX flow has dropped dramatically this year - a reflection of the fact that all of the risk has been wrung out of it. The 06-1 and 06-2 indices could become a good play at the triple-A level once the sub-prime crisis has worked itself out. But at the moment there are plenty of opportunities to access distressed value in Alt-A and prime RMBS collateral, so there's no need to look at sub-prime."
The Wachovia analysts nonetheless note that there is a moderating trend in the ABX remittance data, as well as a growing disparity in credit performance relative to prices. "We harbour no illusions that the ABX trades on credit fundamentals. In our opinion, senior bonds from 2006-1 and 2006-2 are trading at deep discounts compared to the risk of write-down," they say.
July remits show that the increase in new delinquencies was less than in June, with the 60+ delinquencies as a percentage of the original collateral balance falling on average in the 2006-1 index and for 15 of the 20 deals. The other indices saw smaller gains in the measure than last month, the Wachovia analysts say.
Cumulative losses accelerated somewhat as more loans and property is disposed of and losses recognised. The greater seasoning and lower pool factors for 2006-1 and 2006-2 suggest a higher level of confidence with regard to loss estimates.
Meanwhile, 2007-1 and 2007-2 have experienced much slower life prepayment speeds and, thus, are still in the early stages of their loss curves. Loss estimates for these cohorts are likely to be more volatile until more data is gathered.
Three other ABX constituents experienced a write-down this month, following that of SAIL 06-4 M-8 (see last week's issue). MSAC 06-WMC2 B-3 (a 06-2 constituent), HEAT 06-7 B-1 and LBMLT 06-6 M-9 (both 07-1 constituents) were hit, with the write-downs ranging from 29.20% (MSAC) to 61.69% (LBMLT).
Four reference obligations in the 06-1 index have no or low overcollateralisation (less than 10% of required), six in the 06-2 (in addition to the two already taking write-downs), four more on the 07-1 (in addition to HEAT and LBMLT) and two more on the 07-2 index. Structured credit analysts at JPMorgan point out that these are potentially the next wave of bond defaults in the coming months.
SCA restructures ...
As of 30 June 2008, due to significant adverse development on loss reserves, XLCA will report negative statutory surplus and XLFA will report negative total statutory capital and surplus. But upon the successful closing of the transactions contemplated by the Master Transaction Agreement (including XLCA's agreement with Merrill Lynch, see separate news story), XLCA expects to have positive statutory surplus, while XLFA expects to have positive total statutory capital and surplus.
In return for completing the Master Transaction Agreement, XLCA will pay parent SCA US$1.775bn in cash and eight million Class A ordinary shares to SCA's subsidiaries, and transfer its 46% ownership stake in SCA to a trust. It is expected that the trust will be held for the benefit of XLCA until such time as an agreement between XLCA and its financial counterparties is reached, and thereafter such SCA shares will be held for the benefit of the financial counterparties.
In connection with the transfer of the SCA shares, XL Capital will no longer have the right to nominate directors to SCA's board of directors. As a result, Fred Corrado, Paul Hellmers, Gardner Grant and Jonathan Bank are expected to resign from the SCA's board at closing of the Agreement.
"The agreements with XL Capital and Merrill Lynch represent a significant step in the restructuring process of SCA and are critical to our efforts to stabilise the company," comments Paul Giordano, ceo of SCA. "While we are very pleased with the progress made to date, our company remains exposed to potentially significant adverse loss development and there is still much work to be done. In the next phase, we will commence discussions with swap counterparties seeking to commute, terminate or restructure our remaining credit default swaps." After the closing of the transactions contemplated by the Master Transaction Agreement, substantially all reinsurance agreements and guarantees with XL Capital and subsidiaries will be eliminated.
In the absence of the consummation of the transactions contemplated by the Master Transaction Agreement, XLCA and XLFA would likely be subject to regulatory action by their primary regulators, the New York Insurance Department and the Bermuda Monetary Authority. As a result of these developments, there is substantial doubt about the company's ability to continue as a going concern.
The closings of the transactions contemplated by the Master Transaction Agreement are expected to occur concurrently in early August. Further, concurrent with the execution of the Master Transaction Agreement, XLFA has entered into an agreement with Financial Security Assurance to commute all business reinsured by XLFA under reinsurance agreements between the parties.
XLCA has agreed to directly reinsure a portion of such commuted business. In addition, XLFA has entered into agreements to commute certain other ceded reinsurance contracts.
For example, RAM Re has commuted its US$3.5bn portfolio of business assumed from XLFA for a payment of US$94.4m, which includes returning US$8.6m of unearned premium, net of ceding commissions. The commuted portfolio comprises US$2.17bn of par of structured finance transactions, including US$711m 2005-2007 vintage ABS CDOs, US$280m 2005-2007 vintage RMBS, and US$1.3bn of public finance transactions.
The commuted portfolio represents approximately 63% of RAM's total unrealised losses on ABS CDO credit derivatives contracts, 72% of total par outstanding of ABS CDOs for which RAM has established credit impairments, 14% of total loss reserves for RMBS transactions and 16% of total par outstanding of RMBS for which RAM has established case reserves.
Vernon Endo, RAM's ceo, comments: "The commutations represent a milestone in RAM's efforts to reduce risk, which we believe will significantly improve RAM's future prospects. As a result of the XLFA commutation, we have reshaped our insurance portfolio by reducing our overall exposure to 2005-2007 vintage ABS CDOs and US RMBS by more than 55% and 15% respectively."
Meanwhile, SCA has also announced that it will formally change its corporate name on 4 August to Syncora Holdings Ltd. XLCA will consequently become Syncora Guarantee Inc. and XLFA will become Syncora Guarantee Re.
... and the rating agencies react
The rating agencies' reaction to SCA's Master Agreement was mixed, with both Fitch and Moody's querying the 'distressed' nature of the exchange. Fitch downgraded SCA and its subsidiaries, Moody's put them on review, while S&P's ratings remain on watch negative.
Fitch downgraded the IFS ratings from double-B to triple-C and SCA's long-term issuer rating from single-B minus to triple-C minus. It also placed all ratings on rating watch evolving.
The downgrade of SCA and its financial guaranty subsidiaries reflect significant adverse loss development in the company's structured finance CDO and RMBS case basis loss reserves as of 30 June 2008 and the negative statutory surpluses of XLCA and XLFA. Negative statutory capital could result in some form of regulatory intervention, which would cause Fitch to downgrade SCA's IFS ratings to reflect a 'default' status.
The rating watch evolving reflects:
• The uncertainty related to execution of the ML and XL settlements;
• The potential positive implications of enhancements to SCA's financial and capital position if the settlement agreements are executed, which could cause SCA's ratings to be upgraded several rating categories;
• Rating implications tied to Fitch's ultimate viewpoint related to the nature of the negotiations surrounding the noted settlements and terminations.
Regarding the last point, given the perceived favourable terms of the ML and XL settlements agreements from SCA's perspective, as well as SCA's deteriorating financial condition as settlement negotiations were taking place, Fitch may consider the settlements as 'distressed' under its ratings methodology. In this instance, Fitch would potentially downgrade the existing IFS rating of XLCA and XLFA to a 'default' status upon execution of the ML settlements.
This would reflect what Fitch would effectively view as an economic default on those obligations, similar to a distressed debt exchange. Immediately following that action, Fitch would then upgrade the 'post-settlement' IFS rating for XLCA and XLFA to a level reflective of its future financial strength, which would improve significantly as a result of the settlements. Fitch expects to come to its conclusion on the nature of the settlements at the time the settlements are executed.
Any 'post settlement' ratings assessment of SCA would incorporate not only the improvement in SCA's capital position, but also Fitch's view of various qualitative factors. These would include SCA's franchise value and business outlook, which appear to be highly uncertain due to the negative implications from SCA's exposure to mortgage-related credits.
Moody's placed XLCA/XLFA's B2 insurance financial strength (IFS) ratings under review with direction uncertain. The agency also placed the preferred ratings of SCA and a related financing trust on review for possible downgrade.
The review reflects the significant improvement to SCA's capital adequacy position and upward pressure on the ratings that would occur following the successful completion of the transactions, as well as the likelihood of downgrades if the transactions fail to be completed. However, Moody's states that the IFS ratings are likely to remain non-investment grade at the conclusion of its rating review, given the continued uncertainty with respect to SCA's remaining mortgage-related exposures and currently impaired franchise.
The review for possible downgrade of SCA's preferred ratings reflects the potential for the IFS ratings to be lowered in the unlikely event that the Master Agreement fails to close by 15 August, which would have an impact on those ratings due to their subordinated status relative to policyholder claims. Upon the successful closing of the Agreement, Moody's will likely confirm the current ratings on SCA's preferred securities with a negative outlook.
The rating agency states that SCA is expected to record significant reserve charges on its mortgage-related exposures during Q208, including both second-lien RMBS and ABS CDOs. This reserving activity will result in both XLCA and XLFA reporting negative statutory capital at quarter-end.
However, the transactions contemplated by the Master Agreement will, if completed, result in the companies having positive statutory capital and a significant improvement in their capital adequacy positions, in Moody's opinion. But Moody's notes that the negotiated settlement has some elements that are typically associated with a distressed exchange. It will further analyse the terms of the Merrill agreement to determine whether a distressed exchange has occurred, though any conclusions reached from this analysis would not have an impact on the ratings under review.
Meanwhile, S&P says its triple-B minus financial strength ratings on XLCA and XLFA remain on credit watch with negative implications. The agency notes that, while the Agreement would help to stabilise the capital position of XLCA and XLFA, the ratings remain on credit watch because it believes there is execution risk in management's strategy, including possible regulatory intervention, and that business prospects for the companies remain challenging.
The companies' franchise, in S&P's view, continues to be impaired due to their scaled-back underwriting activity, concerns that arose around SCA's ability to address its subsidiaries' capital needs and questions relating to potential CDS losses. Should management prove unsuccessful in implementing a new business strategy and commuting its CDS exposure, notwithstanding a strengthened financial position, the agency believes that XLCA and XLFA would effectively be in runoff - in which case the ratings could be further lowered.
Further European write-downs expected
In a new special comment released today, Moody's expects further write-downs for the large European banks' structured finance portfolios due to continued widening in US sub-prime RMBS spreads and deterioration in the credit quality of financial guarantors, together with falling property prices and the worsening US economic outlook. The second-quarter impact on these banks is likely to be significantly less than what has been observed in Q108, but nevertheless could be substantial in a few cases.
Moody's new report compares the mark-to-market losses taken by large European banks on their structured finance portfolios during Q108 to those expected by Moody's based on an extensive survey of most of these institutions. It then outlines the agency's expectations of how these prospective second quarter markdowns will likely impact the banks' first-half financial results.
With regard to Q108 results, Moody's generally found that the surveyed banks very consistently applied markdowns for those asset classes for which secondary market data is available. "However, for other asset classes for which valuation is more subjective and likely to be model-driven, there was more variation among the banks, with the differences being fairly significant in some cases. For instance, some banks applied notably lower markdowns to their exposures to ABS CDOs, SIVs and financial guarantors than other banks that applied more conservative marks closer to Moody's expectations," explains Anthony Parry, Moody's analyst and co-author of the report.
Moody's expectation of further write-downs in Q208 stems chiefly from two key factors. "Firstly, US sub-prime RMBS spreads continued to widen for 2006 and 2007 vintages during the second quarter, with Aaa marks dropping by a further 5%-10%, which should result in further write-downs mostly for these vintages. Secondly, the downgrades of several financial guarantors and the continued widening of guarantors' CDS spreads will likely lead to further write-downs of banks' financial guarantor exposures," continues Parry. Moody's also expects that the combination of these two developments, together with falling property prices and a worsening US economic outlook, will likely have a negative impact on ABS CDO and SIV marks.
The report - entitled 'Impact of Q2 2008 Spread Movements on Large European Banks' Structured Finance Portfolio' - explains that, based on its survey of large European banks the rating agency expects that the average impact on banks' Tier 1 capital will be a reduction of 6%, with a peak impact of up to 13% of banks' Tier 1 capital.
CDPC moves into munis
Koch Financial Products (KFP) has expanded its operating guidelines to include selling protection on municipal bonds, as well as in tranche and first-to-default CDS referencing corporate and sovereign bonds. The move comes at a time when traditional monoline guarantors appear to be struggling to attract new business in the muni sector.
Under the amendment, KFP will limit its municipal bond reference exposure only to 'full faith and credit reference obligations', as defined under the ISDA 2003 Credit Derivatives Definitions, that are rated at least single-A minus. The CDPC has signed asset management agreements with Koch Financial and Principal Global Investors, which will act as asset manager for its municipal bond and corporate and sovereign bond business lines respectively.
The aggregate notional amount of the company's CDS exposure is US$2.7bn, with a weighted average maturity of 4.5 years. There are more than 110 reference obligors in its portfolio and it has five CDS counterparties, each of which is rated double-A minus or higher. The highest concentration of counterparty exposure, with a double-A rated counterparty, is approximately 26% of the company's total CDS notional amount.
CDO volumes revised upwards
SIFMA has released its quarterly global issuance statistics for CDOs. Q1 issuance volumes have been revised upwards significantly and, although global issuance of funded CDOs has declined again in Q2 compared to the first quarter of this year, the pace of decline has decreased.
Structured credit analysts at UniCredit point out that some interesting market developments can be derived from the SIFMA data:
• The drop in investment grade CDOs from US$7.4 bn (Q1) to US$1bn (Q2) is in line with the decreasing importance of arbitrage CDOs, as opposed to balance sheet transactions.
• Growth was recorded in the issuance of high-yield loan CDOs, increasing by 85% from US$6.1 bn (Q1) to US$11.3bn (Q2) and almost reaching the level of Q407 (US$13.4 bn).
• The importance of euro-denominated CDOs increased, exhibiting a rising issuance volume (+21%), while dollar-based transactions decreased again by another 30%. Short-term transactions (tranche maturities not longer than 18 months) have never been of equal importance as long-term ones. However, the former have not occurred at all in 2008.
• Issuance volumes for cashflow and synthetic funded transactions slightly recovered, while the importance of market value CDOs has further deteriorated, resulting in a net decrease of global issuance in Q2.
In summary, segments with a diffident recovery in funded CDO issuance were CLOs, euro-denominated tranche issuance and balance-sheet transactions. "This development is in line with banks trying to decrease their large volumes of unsold leveraged loans this year, which are still on their balance sheets. Apparently, the primary use of CDOs is currently to clean up banks' balance sheets," the analysts comment.
The SIFMA data comprises all public cashflow, synthetic funded and hybrid transactions. Hence, private non-disclosed transactions, purely synthetic tranches and volumes of index tranche trading are not included.
Additionally, SIFMA statistics do not cover CLOs with loan collateral from SMEs, as such transactions are classified by the Association as ABS. Synthetic issuance, representing primarily private transactions, is estimated to markedly exceed funded CDO issuance in notional volume.
Moody's warns on risks to CLO performance
In a new report issued by Moody's on CLOs the rating agency cautions on significant risks to future CLO performance. It says that in the context of the ongoing sub-prime credit crisis, corporate credit conditions remain negative and the speculative grade corporate default rate is on the rise, while recovery rates of defaulted loans are expected to be lower than their historical average.
However, Moody's reports that CLO ratings have exhibited strong performance since the sector's inception in 1993 until the end of 2007. "Most CLO asset collateral came from a well diversified pool of industries and had experienced lower downgrade rates and higher upgrade rates than like-rated corporate securities outside CLOs during our study period," it says.
Moody's found that during its study period CLOs outperformed corporates and other major CDO asset classes, exhibiting lower default rates, lower loss severity rates, lower loss rates, lower downgrade rates and higher rating stability rates. It says that the good historical performance of CLOs during this period can be largely attributed to the solid performance and unique characteristics of bank loans, the simple and strong CLO transaction structure, and the positive asset selections of most traditional and experienced CLO managers.
But the agency warns that for CLOs that may have less diversified portfolios, may contain a material basket of assets that are not senior secured loans, such as unsecured bonds and other structured finance assets, and may be managed by a less experienced collateral manager, it expects performances to be more sensitive to a corporate credit downturn than a typical CLO.
Banking sector stress affects investor sentiment
New economic worries and stress in the US banking sector have taken a further toll on investor sentiment, according to the latest Fitch Ratings/Fixed Income Forum survey of senior fixed income money managers conducted in June.
Approximately two-thirds of investors now expect the credit markets to stabilise no earlier than 2009, in contrast to the January 2008 survey when most expected stability to return in 2008. Nearly all investors place stability in the housing market as a 2009 or later event and half of investors surveyed believe a recession is highly likely in the US over the coming year.
When asked to comment on the degree of risk posed by a series of key macroeconomic factors, inflation and oil price volatility unsurprisingly registered the biggest gains in terms of factors considered most detrimental to the credit outlook. Survey results confirm that the dramatic spike in oil prices in the first half of 2008 has further clouded the outlook for the US economy, raising the spectre of a slow-growth, high-inflation environment.
In the recent survey there was an interesting divide in opinions on the outlook for the financial sector, with investor expectations essentially split between deterioration and improvement in credit quality over the coming year. However, the failure of a financial institution received the most votes as a high risk factor going forward. This response, given prior to the recent troubles at IndyMac and Fannie Mae and Freddie Mac, held steady even after the first-quarter rescue of Bear Stearns, suggesting strong investor scepticism that the worst of the crisis at financial firms had passed.
"Taken together, the recent batch of survey responses suggests that risk tolerance, at least among more traditional fixed income investors, remains low, which in itself presents a problem for the credit outlook," says Mariarosa Verde, md and head of Fitch credit market research. "Investor confidence is the ultimate ingredient in getting the credit markets back on track."
Survey participants continued to be bearish on the direction of corporate default rates over the next 12 months, with nearly all participants expecting higher default rates. In addition, most investors expect an increase in corporate leverage over the coming year.
"Given the slowdown in the broader economy, it is not surprising that investors expressed the most concern about cyclical industries, the high yield corporate sector, as well as structured finance areas exposed to the housing market," adds James Batterman, md in Fitch's credit policy group. Investors do not anticipate any near-term rebound in issuance in high yield corporate or structured finance.
The Fitch Ratings/Fixed Income Forum Survey is designed to provide insight into the opinions of professional money managers on the state of the US credit markets. In carrying out this survey, the fifth in the series, 72 senior investment professionals representing a wide range of institutions were queried on matters involving the economy, corporate strategies, fundamental credit conditions across various asset classes and industrial sectors, and other relevant topics.
Credit quality deteriorates further
Overall credit quality in Western Europe continued to deteriorate in Q208 as credit markets remain fragile, Moody's says in a new special comment. The agency believes conditions are worsening as European economies grapple with rising inflation and slowing growth, exacerbated by the credit crunch, which is showing no signs of abating. However, rating outlook statistics offer a glimmer of hope, suggesting that credit quality may stabilise over the next 12 to 18 months.
Overall, Moody's downgraded 41 issuers of debt in Western Europe during Q208 and upgraded 12, giving a rating gap of -29, the worst such result since the first quarter of 2003. "The rate of decline in credit quality has accelerated since the first quarter - when the rating gap was -18 - due to a surge in the number of downgrades and a fall in upgrades. Since the credit crunch began, credit fundamentals have deteriorated and the rating gap has remained negative since the third quarter of 2007," says Ruth Stroppiana, chief international economist at Moody's Economy.com and co-author of the report.
On the one hand, despite the more rapid deterioration, Western European overall credit quality remains in better shape than it was in the previous downturn, when the rating gap averaged -40 in 2002. "Nonetheless, credit conditions are worsening, with slowing activity, weakening earnings and tighter monetary policy likely to raise the risks of corporate defaults. The downturn in the current credit cycle is unlikely to be over yet. Indeed, the deterioration in credit quality may well reach similar levels witnessed in 2002. With the global growth weakening, risks remain on the downside," says Christine Li, a Moody's economist and co-author of the report.
Interestingly, speculative-grade issuers are still weathering the downturn reasonably well, whereas the investment grade segment experienced an accelerated rate of deterioration during the second quarter - and non-financial sector speculative-grade issuers actually saw an increase in the number of upgrades. "Unsurprisingly, those speculative-grade issuers that took the opportunity to refinance and extend their debt maturity profiles when credit conditions were good are currently in a better position to withstand the downturn than those that did not," says Kimberly Forkes, a Moody's associate economist and report co-author.
Based on rating review statistics, Moody's anticipates that in 2H08 credit quality among Western European issuers will erode. Of the 52 issuers whose ratings were placed on review in the first half of this year, only 13% were on review for possible upgrade, down from 27% in the second half of last year. "The rapid evolution of the credit crunch has raised the number of Western European issuers placed on review for possible downgrade, whilst the fast-souring economic outlook is spurring an increase in the share of rating reviews that result in actual rating downgrades," Forkes notes.
Moody's believes that - based on rating outlook statistics - there are signs of some stabilisation in credit quality over the medium term. This is particularly the case in the non-financial sector, in which Moody's preferred rating outlook measure saw a small improvement in the second quarter, suggesting that credit quality could stabilise over the next 12 to 18 months following a period of decline.
Fannie and Freddie plan passes
The US Treasury's support plan for Fannie Mae and Freddie Mac has been added to the Housing Reform Bill, HR 3221, which passed votes in both the House and the Senate. Although there is still ambiguity on the part of regulatory authority as it applies to how non-senior creditors of the GSEs would be treated if the US Treasury ever acted on its plan, the language in HR 3221 increases the likelihood that subordinated debtholders and preferred stockholders would face greater subordination risk.
The plan includes provisions to:
• Help homeowners refinance into a lower-cost government-insured mortgage
• Increase the size of the mortgages that both FNMA and FHLM can buy up to 115% of local median home price, with a loan limit cap of US$625,500
• Provide up to US$7,500 tax credit for first-time homebuyers
• Create an independent regulator with the power to increase capital standards and set executive pay
• Establish a national licensing system for mortgage brokers and loan officers.
The move led S&P to affirm its AAA/A-1+ senior unsecured debt ratings on the GSEs. At the same time, the agency placed its double-A minus risk-to-the-government, subordinated debt and preferred stock ratings on Freddie Mac, and its double-A minus subordinated debt and preferred stock ratings and single-A plus risk-to-the-government rating on Fannie Mae on credit watch negative.
The affirmation of the senior unsecured debt ratings reflects the strong explicit and implicit support these GSE securities hold in the marketplace. Government support by the US Treasury underscores the key public policy role and the key liquidity role the congressional chartered GSEs have in the US mortgage markets. This is reflected in the current stable outlook on the senior unsecured debt.
Both firms face weak earnings due to rising credit expenses. The watch listing on the subordinated debt, preferred stock and risk-to-the-government ratings underscores the expected higher stress on capital and earnings these firms face during the next several quarters. The confidence crisis in the equity markets is adding to the already stressed business cycle and creates additional challenges in the near term for capital-raising initiatives.
In addition to a detailed review of the final version of the Housing Reform Bill, S&P will reassess its view of the respective firms' earnings, credit performance and capital adequacy levels. Currently, both firms operate with a solid capital position above the regulatory minimum capital requirements, but with a lower capital cushion above the regulatory surplus requirement.
If the agency believes that operating losses reach a level that significantly reduces the surplus capital position and further threatens capital-raising efforts to support the respective businesses, it could lower the subordinated debt and preferred stock ratings one to two notches. The risk-to-the-government ratings could either be affirmed or lowered one notch.
IMF reports on market turmoil
A year after the sub-prime market crisis erupted in the US, triggering financial market turmoil around the world, global financial markets continue to be fragile and systemic risks remain elevated, the International Monetary Fund (IMF) says in its latest assessment.
"Credit quality across many loan classes has begun to deteriorate with declining house prices and slowing economic growth. Although banks have succeeded in raising additional capital, balance sheets are under renewed stress and bank equity prices have fallen sharply," the IMF's 'Global Financial Stability Report Market Update' notes.
The update says that banks have been fairly successful in raising equity so far, amounting to about three-fourths of the write-downs to date, adding that IMF analysts had little reason to change earlier estimates of aggregate potential losses from the crisis of US$945bn published in April. However, the renewed stress has made raising additional capital more difficult and increased the likelihood of a negative interaction between banking system adjustment and the real economy.
"At the same time, policy trade-offs between inflation, growth and financial stability are becoming increasingly difficult. The resilience of emerging markets to the global turmoil is being tested as external financing conditions tighten and policymakers face rising inflation," the report adds.
The IMF expects global growth to slow significantly from 5% in 2007 to 4.1% in 2008 and 3.9% in 2009. Updated forecasts in the IMF's World Economic Outlook (WEO) also raised inflation projections, particularly for emerging markets and developing countries.
The IMF's market assessment says that, as banks seek to deleverage and economise on capital, assets are being sold and lending conditions are tightening, which will result in slower credit growth in the US and euro area. With inflation risks on the rise, the scope for monetary policy to be supportive of financial stability has become more constrained.
In Q108, total US private sector borrowing growth fell to 5.2% - a level last seen after the 2001 recession. With continuing pressures on banks to deleverage, this growth might slow further.
The report stresses the need to stem the decline in the US housing market to help both households and financial institutions to recover. "At the moment, a bottom for the housing market is not visible," it says. House prices are softening in a number of other European economies, prompting concerns over future loan losses in the mortgage, construction and commercial property areas.
Jaime Caruana, director of the IMF's monetary and capital markets department, notes that extraordinary steps by central banks in mature markets had succeeded in capping systemic risk. "However, in the context of the deleveraging process and uncertainty about asset valuations, credit risks remain elevated, indicating that further raising of capital may be needed in a number of financial institutions," he states.
He adds: "In this phase of the crisis, the nature of resolution strategies and the extent of government support have come into sharper focus. Financial market disruptions will still need to be dealt with on a case-by-case basis and there is no iron-clad rule-book as to how to handle such instances in today's more global environment. Prompt and transparent government responses, however, will go a long way to relieving the uncertainties."
Structured credit valuation service launched
Julius Finance has launched an independent valuation service for a range of credit derivatives, including bespoke synthetic CDOs, CDO-squareds, CDO-cubeds, CPPIs, CPDOs and CDPCs. The firm says that the valuation service makes use of its breakthrough research in model fusion, which is uniquely able to price such securities by taking account of all market available information through a next-generation unified credit model.
The technology provides unprecedented visibility for market-derived pricing and analytics. The service is designed for bespoke valuation, risk management, catastrophic risk analysis, portfolio management, scenario analysis, structured/hybrid products and trading. Julius also provides market-driven tail risk estimates for CDS and corporate bond portfolio managers.
European CDO rating actions
S&P has taken credit rating actions on 102 European synthetic CDO tranches. Specifically, the ratings on 41 tranches were lowered and removed from credit watch with negative implications; three tranches were lowered and remain on watch negative; 17 tranches were removed from watch with negative implications and affirmed; 27 tranches were removed from watch with positive implications and raised; and 14 tranches were raised.
Of the 44 tranches lowered, 30 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 14 have experienced corporate downgrades in their portfolios.
Next steps for CRA code of conduct
The International Organization of Securities Commission's (IOSCO) Task Force on Credit Rating Agencies has announced its next steps with regard to the monitoring of compliance with the Code of Conduct Fundamentals for Credit Rating Agencies. The Code of Conduct focuses on transparency and disclosure in relation to CRA methodologies, conflicts of interest, use of information, performance and duties to issuers and the public.
IOSCO believes that, for the Code of Conduct to be effective, CRAs need to comply with the prescribed disclosures and regulators should take steps to determine the veracity of these disclosures. The Task Force is currently exploring the means by which its members might work together to verify the proper and complete disclosure by CRAs of information required by the Code of Conduct, and adherence to the mechanisms it contains designed to protect against conflicts of interest.
As part of this project, the Task Force will be considering a number of options for the effective monitoring of compliance with the Code of Conduct, including the potential for:
• Detailed arrangements for exchanging information between national securities regulators;
• Cooperative inspection programmes for CRAs; or
• A specialised IOSCO committee to confer on compliance with the Code of Conduct by CRAs.
In its deliberations IOSCO also will review members' recent and upcoming rule proposals. The Task Force will submit its final recommendations to the Technical Committee at its next meeting in September 2008.
Fitch reviews SME CLO assumptions
Fitch is reviewing its default assumptions for SME CDOs, as part of its updated CDO methodology approach. SME borrowers typically do not benefit from public or shadow ratings on the standard scale, so other methods have been employed to assess the underlying credit quality.
"For the majority of SME CDOs in Europe, we have assessed credit quality by analysing vintage default data provided by the issuer, or by mapping an issuer's internal rating scale to our corporate rating scale," says Phil McDuell, md and head of structured credit for EMEA and Asia Pacific at Fitch. "Our current review is focused on ensuring that default risk patterns of SME loans are reflected in the assumptions, and that the data review process is robust and consistent."
Another important element of the review relates to the cyclicality of default data. "Recent portfolio default data provided by issuers tend to be skewed towards the 2002-2006 period, which represents a period of benign economic conditions in Europe," says Emmanuelle Nasse-Bridier, md and head of structured finance for continental Europe at Fitch in Paris. "We need to make adjustments for cyclical default patterns where the data provided may underestimate long-term default prospects."
Finally, Fitch highlights the additional risk that large borrower exposures may bring to SME CDOs. The portfolio approaches to assessing underlying credit quality may not adequately highlight the risk of a large individual borrower exposure in an SME CDO.
"Our updated approach to corporate CDOs focuses heavily on concentration risk," says McDuell. "We are assessing the circumstances in which a full corporate credit assessment or shadow rating may be necessary to fully address obligor concentration risk."
Fitch expects to complete its analytical work on this sector later this year.
CS & AC
